Stochastic MACD Strategy is based on one of the most common combinations of indicators. The strategy combines popular MACD trend-following strategy and classic Stochastic rebound strategy.
It is known that Stochastic Indicator works badly in trending markets. In other words, trend distorts Stochastic Indicator readings and produces false signals. In its turn, MACD indicator gives false signals during stagnating, lateral movements of the market. The combination of this two indicators aims to take the best qualities of each.
Short description of Stochastic
There are two components to the Stochastic oscillator the %K and the %D lines. The %K called Stochastic line, is the main line and represents Stochastic oscillation of the price for the last N bars. %D or the Signal line represents Moving Average of the %K line and shows momentum and trend of the indicator. As the classic oscillator, Stochastic ranges between 100 and 0. Ground rules for the Stochastic Oscillator:
- Stochastic line %K drops below 20 – asset is oversold; %K line rises above 80 – asset is overbought
- %K line is higher than %D line – asset is in uptrend; Stochastic line is lower than %D line – downtrend
Description of MACD
MACD consists of two components: MACD histogram and Signal line. MACD histogram is the difference between two Moving Averages. The signal line is the Moving Average of the MACD histogram; it is used to spot trend and peaks in the indicator. As MACD represents the difference between two MA, it is not ranged between max and min values. MACD oscillates about the zero line. Rules for MACD:
- MACD histogram higher than zero line – asset is in uptrend; MACD histogram lower
- Histogram crossing the Signal Line from bottom-up – uptrend signal or end of the downtrend; MACD histogram crosses the Signal line from above-down – downtrend or end of the uptrend
Rules for the strategy
The strategy consists of two logical steps: first – determine trend direction with the help of MACD Indicator; second – determine entry point within trend direction with the Stochastic Oscillator Indicator.
Since we are using MACD as trend filter and Stochastic as trade trigger, MACD should have a bigger period than Stochastic Oscillator. For intraday trading on forex pair EURUSD we recommend the following settings:
Timeframe – 15m; MACD (24, 200, 14); Stochastic (9,5,3)
- Any trading instrument is suitable
- To avoid the impact of market noise we recommend to use time frames higher than 15 min;
- Install Stochastic Oscillator (we recommend following settings Stochastic (9,5,3);
- Install MACD (we recommend following settings MACD (24,200,14);
Longer period MACD (24,200,14) shows weekly trend direction. Stochastic (9,5,3) shows entry points.
The strategy follows simple rules: MACD shows current trend direction; Stochastic Oscillator shows entry points; Trades are open in the trend direction.
- MACD higher than 0 level
- Stochastic line %K is greater %D and crossing 20 level from bottom-up
- MACD lower than 0 level
- Stochastic line %K is lower than %D crossing 80 level from above-down
The strategy allows several exit rules. In addition to the stop loss and take profit Stochastic Oscillator will be used to determine an end of the trading impulse.
There are several rules to evaluate Stop Loss, which underlay different risk levels. Usually, Stop-Loss set to the support levels and pivot points. These rules are listed for the Buy signal, for the Sell signal rules should be vice versa.
- Closest lower Pivot Point
- Minimum of the last bar (Suitable for the high time frames, 4h, 1D, 1W)
- Minimum of the current day
- Current Price – k* ATR (Average True Range show average price motion; k between 2 and 5)
Take Profit is the desired level of profit and must correlate with Stop Loss level. One of the most important indexes of the strategy is relation SL/TP. This relation is called risk/reward level of the strategy. (rules are for the Buy signal):
- Last Pick (Visual Pick of the price for the reasonable period)
- Closest upper Pivot Point
- Maximum of the last bar (Suitable for the high time frames, 4h, 1D, 1W)
- Current price + k*Standard Deviation (Standard Deviation indicator stands for an average price motion; k between 0.5 and 1)
- Current price + k*ATR (ATR – average true range, calculated on a different principal than Standard Deviation; k between 0.5 and 2)
Early exit rules
In this strategy, Stochastic Oscillator reflects intraday price peaks and reversals on which trader enters the market, reverse signals of this indicator serve for exit signals. Nevertheless, MACD Indicator, which shows trend direction also should be considered.
Rules for closing the Buy trade:
- Stochastic line %K crossed 20 level from above-down
- Line %K crossed signal line %D from above-down
- Line %K reached 80 level and crossed it from above-down
- MACD indicator loses momentum or crosses zero level from above-down (MACD histogram rapidly approaching zero. Mainly determined visually)
This chart demonstrates several Buy signals in a row, all closed by the Early exit rules. Note that decreasing MACD accompanies calming market.
The chart demonstrates sell trades during a downtrend. Stop Loss level are 60 pips, according to the weekly maximum and ATR level; Take Profit are 30 pips; All trades were closed by the early exit rules.
Straightforward and profitable strategy, works best in trending markets.
Strategy gives false signals during stagnating market periods.