Using the Stochastics Indicator and the MACD to Create a Trading Strategy
Although the Stochastics indicator is effective in detecting trading signals when the currency market is in a trading range, it becomes more effective when combined with a compatible indicator such as the moving average convergence divergence (MACD). The two indicators work well together because Stochastics compare the closing price of a security to its price range over a particular period while MACDs form two moving averages that converge or diverge. When there are a bullish Stochastic crossover as well as a bullish MACD indicator crossover, there is a good entry point to start a trade.
The Stochastics indicator can potentially move within a range of zero to 100 on a chart. Stochastics uses two lines, with the %K being the main line while the %D line is a moving average of the %K line. If the %K line moves above 80 it is a signal that a currency is overbought and if it is below 20 it is oversold. If a currency is overbought it means that a currency is overpriced because of excessive market demand and is due for a correction. Oversold currencies, on the other hand, have a price that is too low due to market overselling. Overselling is considered a signal to buy a currency pair while overbuying is a sell signal if you are short-selling the currency. However, if the %K line peaks just below the 100 level and then drops, you should sell the currency just before it reaches 80.
MACD, on the other hand, uses two price lines based on various exponential moving averages. Exponential moving averages are like simple moving averages but more weight is given to the newest exchange rate data. While traders can use any two periods when using MACD indicators, you can simply use the default 12-day and 26-day EMAs to create the indicator. The difference between the two indicators is computed and plotted on a chart and this is the MACD indicator. In order to reveal trading signals, a ‘signal line’ is charted using the MACD’s nine-period average. When the MACD line moves over the signal line, it is considered to be ‘bullish’ and is a signal to buy a currency pair and once it moves below, it is seen as a ‘bearish’ signal to sell.
To use the Stochastics indicator and the MACD in your trading strategy, simply chart both and look for signals that a currency is overbought or oversold as described above. Then look at the MACD to see what direction it is moving in to confirm your analysis. You should also compare the Stochastics indicator and the closing price to determine if there is a divergence between them that could signal that the trend is about to change. For example, if the price is moving downward but the %K line is moving upward, it is a signal of a bullish market while if the opposite happens, it is a bearish market. Make your trading decisions accordingly with the confidence that the use of the two indicators has confirmed your trading signal.
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