Astute technical traders and chartists have heard of both the stochastic and moving average convergence divergence (MACD) indicators helping to isolate ranging opportunities in currency pairs in the foreign exchange market. Although both are easy and simple to use, their technical influence tends to wane a bit as the price action turns into a trending environment. However, by combining the power of both oscillators, traders can isolate profitable setups in the market that are of higher probability than when these indicators are used individually. In this article, we'll show you how to apply this concept to your personal trading strategy.
Stochastic and MACD
Before diving into the intricacies of the combined strategy, let's first briefly review how to interpret both the stochastic and MACD oscillators.
The stochastic oscillator was developed in the 1950s and is used to show the positioning of the current close relative to the high/low range of the currency over a period of time. The indicator shows buying or selling pressure in the market. Consistently higher levels reflect buying support in the market, while comparatively lower levels indicate of selling pressure. As a result, the oscillator uncovers extreme readings in price levels, showing overextended momentum through barriers set at 20 and 80. Readings below the 20 reference mark indicate that the market has been oversold; readings rising above 80 represent overbought conditions.
The stochastic oscillator is able to isolate tops and bottoms in the market that correspond with support and resistance in range-bound channel environments. Because of this, the stochastic oscillator is great for short-term trading. (To learn more, read Exploring Oscillators And Indicators: Stochastics Oscillator.)
Used in range-bound markets, the MACD oscillator is based on moving averages (a 26-day and 12-day exponential moving average (EMA) with a trigger moving average established by a nine-day exponential moving average).
Notably, instead of showing overbought or oversold conditions, MACD shows the relationship between prices. As a result, and similar to simple moving average crossovers, bullish and bearish sentiment will be triggered on a move higher or lower in the indicator's moving averages. For example, a bullish signal is produced when the MACD (difference between the 12- and 26-day moving averages) rises above the trigger line (nine-day EMA). This oscillator is great for longer-term trends. (For more insight, check out Exploring The Exponentially Weighted Moving Average.)
Trading on the "Snap"
If we take both tools into consideration, the underlying theme with trading a "snap" setup relies on the strengths of both indicators. Establishing the longer term trend in the MACD, the trader is able to create entry opportunities in the foreign exchange market using the stochastic as a reference. However, in this case, most traders will choose to adjust the parameters of the indicator so that the number of periods corresponds to the longer-term trend. Ultimately, a longer, smoother stochastic D% line is the best way to confirm the directional bias with the MACD line as in Figure 1.
|Source: FX Trek Intellicharts|
|Figure 1: Stochastic and MACD show the directional bias in the market.|
In Figure 1, both the MACD and Stochastic D% line move in tandem over the span of 24 hours in the euro/Japanese yen currency pair. Although the MACD does lag behind the stochastic visual, it virtually confirms the longer term upside bias in the currency pair. Now, with the longer term bias established, the trader or currency speculator will begin entering when the shorter K% stochastic line "snaps" back upward or rejoins the overall upward trend. Our first example is shown at Point A.
With the currency pair declining over the last 24 hours, the momentum seemed to be turning as price begins to consolidate. The notion is confirmed by what seems to be a turn in the stochastic, later confirmed by the turn in MACD. As a result, after seeing the confirming uptick in the longer term MACD trend, the trader sees the opportunity as the K% line turns up and rejoins the longer term upward direction of the market. Ultimately, with a corresponding stop placed at the previous session low, the trader is able to capture the short-term burst that occurs in the price action.
Putting It All Together
Now let's take an easy, step-by-step approach to applying the "snap" setup in the New Zealand dollar/Japanese yen currency cross (Figure 2). After declining over the last 24 hours, the market looks to take the pair higher, as both the stochastic and MACD oscillators have turned upward. Notably, it is good to remember at this point that the stochastic oscillator has been revamped to reflect settings of 7, 3 and 20, rather than remaining at the standard settings. (For more insight, read Make The Currency Cross Your Boss.)
- Establish the trend. With stochastic D% line turning upward first, the trader looks for a confirming rise/crossover in the MACD, establishing the longer term trend.
- Take positions in the direction of the trend. In the trade example presented in Figure 2, the speculator would be looking to take a long position as both stochastic and MACD have turned higher. As a result, our first trade will be at Point B.
- Assess the position. With the trade setup in place, a long position is taken at the "snap", placing the entry at the close of the hourly session, 94.29. Subsequently, the stop would be placed at the session low of 94.01, keeping in time with disciplined risk management. As the trade unfolds, a trailing stop is applied to the position in order to further gains and minimize substantial moves against the outstanding buy. As a result, the full length of the move to 95.88 gives the trader ample reward - 159 pips overall - before any initial take-back is seen.
|Source: FX Trek Intellicharts|
|Figure 2: A perfect "snap" setup in the NZD/JPY currency pair|
When used individually, both technical oscillators help to isolate great opportunities in a range-bound market. The stochastic indicator can be aptly applied for short-term trades, while the MACD is best used for longer term opportunities. Together, however, they are able to harness the power of market dynamics as short-term price action rejoins the longer term trend, offering further potential in changing market conditions.