Swing Trading Using Stochastic and the Simple Moving Average
Many traders are familiar with the Stochastic Indicator as well as the Simple Moving Average. And many of these technical traders are using one or the other, but did you know that you could combine both of these studies to create a robust trading strategy? That is the topic for this article. We will go through the basics of each of these technical studies, and learn how we can combine the best elements of each indicator to create a viable swing trading approach.
Understanding the Stochastic Indicator
The Stochastic indicator was created by George Lane. It helps to measure the momentum in a financial instrument. And momentum, in terms of trading, measures the rate of acceleration for price action. By analyzing momentum, we can get a jump start on a price retracement or trend reversal, because the change in momentum tends to precede price shifts.
The Stochastic indicator looks at the price range over a specified period of bars. It takes the high or low within that range can combines it with the closing price for that period to calculate an output value between 0 and 100. The typical look back period is 14 bars. The indicator plots the %K value, which is the Stochastic value and the %D value which is the smoothed average of the %K line.
Let’s take an example.
Let’s assume that the look back period is 14 bars, and the highest price within that period is 50, the lowest price within that period is 40, and the closing price within that period is 48.
Based on this, the Stochastic indicator would calculate the output as follows for the 14 period look back:
Highest high : $ 50
Lowest low : $ 40
Closing price : $ 48
Stochastic indicator value =
(Closing price – Lowest low) / (Highest high – Lowest low) x 100
From our example above, the Stochastic value would be:
(48 – 40 ) / (50 – 40) x 100 = 80 %
There are various ways that a trader can use this information. You can use Stochastics to trade breakouts from consolidation, pullbacks within a trend, or mean reversion strategies. But the most important concept to remember when trading Stochastic or any indicator for that matter is market context.
For example, you do not want to take counter trend trades on Overbought or Oversold signals in Stochastics when the market is trending strongly. Even though the Stochastic indicator may be showing an Overbought or Oversold reading, the reality of the matter is that the market keeps closing within its upper or lower range and as such a mean reversion strategy is prone to many false signals under this type of market environment.
Let’s take a look at the Stochastic Indicator on the chart:
You will notice the Fast line %K plotted in blue, and the Slow line %D plotted in red.
Filtering Signals With Moving Averages
Moving Averages are popular technical studies that are used by many traders around the world. Generally, moving averages are not the best market timing tools, however, they are quite effective when it comes to filtering trades based on trend. Two of the more widely used Moving Averages including the Exponential Moving Average and Simple Moving Average.
Exponential Moving averages weigh recent price action more heavily in its calculation, while Simple moving averages calculate each point for the specified period on an equal weighting. From my personal experience, I have found the Simple Moving Average to be more robust over the Exponential Moving Average. And so, due to its simplicity and robustness, I will typically choose it over all other types of moving averages in my analysis.
The basic idea is to trade only from the long side when price is above the Simple Moving average and to trade only from the short side when price is below the Simple Moving average. You would use a more sensitive trading signal such as the Stochastic indicator for the actual trade entry.
So then, the next obvious question becomes: Which period should I use for the Moving Average? Well, there is nothing set in stone that says that a certain period moving average is always better than another. However, having said that, it makes sense to use a setting that is widely watched by major market participants such as Hedge Funds, Banks, and CTAs.
These players are the ones that can move markets, and as such we want to be watching what they are watching. I prefer to use the 50 period SMA or 200 period SMA as my directional bias, because these two periods are the most widely monitored by major market players.
The chart below shows the 50 period and 200 period moving average plotted on a price chart:
Swing Trading Strategy Combining Stochastic and SMA
Now that you have a basic understanding of the Stochastic Oscillator and the Simple Moving Average indicator, let’s shift our focus to building a swing trading strategy around these studies.
But first, let’s clearly define what I mean by a swing trading. I consider swing trading to be a short to intermediate term time frame. Typically, swing traders look to hold a position from a few days to a few weeks or so. Swing traders will usually look at 120 min, 240 min and daily chart for their analysis.
So, the swing trading strategy that I will describe includes the following conditions:
We will look to enter a long trade when %K of Stochastic (fast line) crosses over %D of Stochastic (slow line) during an oversold condition (Stochastic reading of 25% or lower) and price is above both the 50 and 200 period Simple Moving Averages.
We will look to enter a short trade when the %K of Stochastic (fast line) crosses below the %D of Stochastic (slow line) during an overbought condition (Stochastic reading of 75% or higher) and price is below both the 50 and 200 period Simple Moving Averages. The look back for Stochastic will be 14 period.
The stop loss placement should be just beyond the recent swing and the take profit target will occur when price closes beyond the 50 period SMA in the opposite direction.
So, the logic behind this swing trading strategy is 1) Trade with the longer-term trend 2) Find a pullback opportunity within the trend 3) Enter on a momentum shift in the direction of the trend. 4) Cut the loss short on a losing trade and 5) Let the profits run on a winning trade.
It’s as simple as that, and the strategy is grounded in sound trading principles.
Stochastic and SMA Trading Example
Now that we have put our swing trading strategy together, let’s take a look at an example of how this strategy would play out in the markets.
Below is the 240-minute price chart for the EURUSD currency pair:
Notice that the EURUSD was in a downtrend, as can be confirmed by the price action, which is below both the 50 period and 200 period SMA. The price retraced a bit to the upside and tested the 50 Period SMA but it could not stay above that resistance. Soon the Stochastic indicator entered an oversold level (over 75%) and the Stochastic %K line crossed below the %D line. This was our short entry signal.
The stop would be placed beyond the recent swing high formed by the price rejection at the 50 period SMA. After the entry signal, prices continued to push lower, and stayed below the 50 period SMA for quite some time. Then prices began to make higher highs and eventually reached the 50 period SMA again. This time the test resulted in price closing above it, and this would serve as our take profit target and exit signal.
Hopefully, you have a better appreciation now for both the Stochastic indicator and the Simple Moving Average. As we have shown, combining both of these studies can provide a simple, yet robust method for trading the markets.
This guest post was written by Vic Patel. He is a private trader and educator with 20+ years’ experience in the financial markets. He is also the founder and head trader at Forex Training Group.