Forex Trading Using MACDs and Stochastics

Most Forex traders recognise that a trading system or formula is essential to help identify a change in the course of a price pattern. Whilst there are many types of indicator we will look at two of the most commonly observed indicators, MACD’s and Stochastic.

The aim of finding a workable formula is to identify a signal and a signal confirmation.  By using two as opposed to one signal effectively doubles the chance of being correct. However if you apply that logic it can be misleading to say if you apply 10 indicators it’s an even higher probability of being right. If you use too many indicators you will get trading signals so infrequently that any failure will undermine the whole trading strategy. Waiting 3 days for a buy signal that is incorrect will dent confidence and inevitably negate the ability to trade the method with any confidence.

Macd’s and Stochastic both indicate money flow and momentum in different ways and show two lines each. Without wanting to over simplify, if both are pointing down on a chart the trend would be to be short and vice versa.  The aim of the trader is usually to anticipate and try and identify the change in direction.  As with most trading methods this has to be looked at in conjunction with time frames. The shorter the time frame the more unreliable the signal in some respect. For instance a change and line crossover on a five minute chart really signals that the change of direction is only likely to last 5 minutes.  With this in mind you should start your signal search on a longer term chart, normally hourly for day traders.

The most basic signal is a line crossover. These are known either as a death cross (turning bearish) or a golden cross (turning bullish). For the strongest trade set up traders can look for a weakening longer term MACD and stochastic. This would be where the faster measurement of the two lines is beginning to flatten and head towards the slower line. For an even stronger signal a trader would look for the turn as far from neutral as possible.

Once identified on a longer term chart you can look at shorter term charts to craft an entry point, still using the same method but using the cross over as the trigger but remembering the shorter the time frame the more unreliable the signal.

The chart below illustrates a good sell signal on an hourly chart and the subsequent price action.

The MACD sell signal was confirmed by the shorter term stochastic shown below the MACD.  The signal appears correct as the price action moved downwards.  The next consideration of course is where to place take profit and stop loss levels.  Using MACD’s to pre determine a take profit entry will not work as it is a live or fluid situation.  Using the MACD as a signal generator can only be executed by reacting to change not anticipating change. A trader’s take profit will be determined by the same action that prompted the entry into the trade but in reverse, so looking for the MACD’s to turn back up on the shorter term chart whilst the momentum on the longer term chart begins to slow and ideally in an overstretched position away from neutral.

To summarise trading with MACD’s and Stochastic.

• Use variations of time frame and check each time frame before making a trade.
• Use the stochastic move as the first alert as it is first to move.
• Check the trade is not occurring to close to neutral and ideally at an overstretched position.
• Remember this signal method will not give a pre determined exit or stop loss level.
• The trigger point is either a death or golden cross on the MACD.

We will look at where to place stop loss levels in a later blog. There are examples in Trading Forex Using Trend Lines and explains other trading methods.

For more information and a demo download with MACD and Stochastic chart facilities please contact VantageFX UK.