MACD And Stochastic: A Double-Cross Strategy

Ask any technical trader and he or she will tell you that the right indicator is needed to effectively determine a change of course in a stocks’ price patterns. But anything that one “right” indicator can do to help a trader, two complimentary indicators can do better. This article aims to encourage traders to look for and identify a simultaneous bullish MACD crossover along with a bullish stochastic crossover and then use this as the entry point to trade.

Pairing the Stochastic and MACD
Looking for two popular indicators that work well together resulted in this pairing of the stochastic oscillator and the moving average convergence divergence (MACD). This team works because the stochastic is comparing a stock’s closing price to its price range over a certain period of time, while the MACD is the formation of two moving averages diverging from and converging with each other. This dynamic combination is highly effective if used to its fullest potential. (For background reading on each of these indicators, see Getting To Know Oscillators: Stochastics and A Primer On The MACD.)

Working the Stochastic 
There are two components to the stochastic oscillator: the %K and the %D. The %K is the main line indicating the number of time periods, and the %D is the moving average of the %K.

Understanding how the stochastic is formed is one thing, but knowing how it will react in different situations is more important. For instance:

  • Common triggers occur when the %K line drops below 20 – the stock is considered oversold, and it is a buying signal.
  • If the %K peaks just below 100, then heads downward, the stock should be sold before that value drops below 80.
  • Generally, if the %K value rises above the %D, then a buy signal is indicated by this crossover, provided the values are under 80. If they are above this value, the security is considered overbought.

Working the MACD
As a versatile trading tool that can reveal price momentum, the MACD is also useful in the identification of price trend and direction. The MACD indicator has enough strength to stand alone, but its predictive function is not absolute. Used with another indicator, the MACD can really ramp up the trader’s advantage. (Learn more about momentum trading in Momentum Trading With Discipline.)

If a trader needs to determine trend strength and direction of a stock, overlaying its moving average lines onto the MACD histogram is very useful. The MACD can also be viewed as a histogram alone. (Learn more in An Introduction To The MACD Histogram.)

 

MACD Calculation 
To bring in this oscillating indicator that fluctuates above and below zero, a simple MACD calculation is required. By subtracting the 26-day exponential moving average (EMA) of a security’s price from a 12-day moving average of its price, an oscillating indicator value comes into play. Once a trigger line (the nine-day EMA) is added, the comparison of the two creates a trading picture. If the MACD value is higher than the nine-day EMA, then it is considered a bullish moving average crossover.

It’s helpful to note that there are a few well-known ways to use the MACD:

  • Foremost is the watching for divergences or a crossover of the center line of the histogram; the MACD illustrates buy opportunities above zero and sell opportunities below.
  • Another is noting the moving average line crossovers and their relationship to the center line. (For more, see Trading The MACD Divergence.)

Identifying and Integrating Bullish Crossovers
To be able to establish how to integrate a bullish MACD crossover and a bullish stochastic crossover into a trend-confirmation strategy, the word “bullish” needs to be explained. In the simplest of terms, “bullish” refers to a strong signal for continuously rising prices. A bullish signal is what happens when a faster moving average crosses up over a slower moving average, creating market momentum and suggesting further price increases.

  • In the case of a bullish MACD, this will occur when the histogram value is above the equilibrium line, and also when the MACD line is of a greater value than the nine-day EMA, also called the “MACD signal line.”
  • The stochastic’s bullish divergence occurs when %K value passes the %D, confirming a likely price turnaround.

Crossovers In Action: Genesee & Wyoming Inc. (NYSE:GWR)
Below is an example of how and when to use a stochastic and MACD double cross.

Note the green lines that show when these two indicators moved in sync and the near-perfect cross shown at the right-hand side of the chart.

You may notice that there are a couple of instances when the MACD and the stochastics are close to crossing simultaneously – January 2008, mid-March and mid-April, for example. It even looks like they did cross at the same time on a chart of this size, but when you take a closer look, you’ll find that they did not actually cross within two days of each other, which was the criterion for setting up this scan. You may want to change the criteria so that you include crosses that occur within a wider time frame, so that you can capture moves like the ones shown below.

It’s important to understand that changing the settings parameters can help produce a prolonged trendline, which helps a trader avoid a whipsaw. This is accomplished by using higher values in the interval/time-period settings. This is commonly referred to as “smoothing things out.” Active traders, of course, use much shorter time frames in their indicator settings and would reference a five-day chart instead of one with months or years of price history.

The Strategy
First, look for the bullish crossovers to occur within two days of each other. Keep in mind that when applying the stochastic and MACD double-cross strategy, ideally the crossover occurs below the 50 line on the stochastic to catch a longer price move. And preferably, you want the histogram value to be or move higher than zero within two days of placing your trade.

Also note that the MACD must cross slightly after the stochastic, as the alternative could create a false indication of the price trend or place you in sideways trend.

Finally, it is safer to trade stocks that are trading above their 200-day moving averages, but it is not an absolute necessity.

The Advantage
This strategy gives traders an opportunity to hold out for a better entry point on uptrending stock or to be surer that any downtrend is truly reversing itself when bottom-fishing for long-term holds. This strategy can be turned into a scan where charting software permits.

The Disadvantage 
With every advantage that any strategy presents, there is always a disadvantage to the technique. Because the stock generally takes a longer time to line up in the best buying position, the actual trading of the stock occurs less frequently, so you may need a larger basket of stocks to watch.

Trick of the Trade
The stochastic and MACD double cross allows for the trader to change the intervals, finding optimal and consistent entry points. This way it can be adjusted for the needs of both active traders and investors. Experiment with both indicator intervals and you will see how the crossovers will line up differently, and then choose the number of days that work best for your trading style. You may also want to add an RSI indicator into the mix, just for fun. (Read Ride The RSI Rollercoaster for more on this indicator.)

Conclusion
Separately, the stochastic oscillator and MACD function on different technical premises and work alone. Compared to the stochastic, which ignores market jolts, the MACD is a more reliable option as a sole trading indicator. However, just like two heads, two indicators are usually better than one! The stochastic and MACD are an ideal pairing and can provide for an enhanced and more effective trading experience.

For further reading on using the stochastic oscillator and MACD together, see Combined Forces Power Snap Strategy.

 

5 Profitable Trading Strategies Using the MACD

Are you an indicator trader? If yes, then you will enjoy reading about one of the most widely used trading tools – the moving average convergence divergence (MACD). Today, we will cover 5 trading strategies using the indicator and how you can implement these methodologies within your own trading systems.
What is the MACD?
The moving average convergence divergence calculation is a lagging indicator, used to follow trends. It consists of two exponential moving averages and a histogram as shown in the image below:
The default values for the indicator are 12,26,9.
It is important to mention that many traders confuse the two lines in the indicator with simple moving averages.
The slower line of the moving average convergence divergence is calculated by placing a 12-period EMA on the price and then smoothing the result by another 26-period EMA. The second line is calculated by smoothing the first line by a 9-period EMA. Thus, the second line is faster and hence is the “signal” line.
The last component of the indicator is the histogram, which displays the difference between the two MAs of the indicator. Thus, the histogram gives a positive value when the fast line crosses above the slow line and negative when the fast crosses below the long.

What signals are provided by the MACD?

  1. Moving Average cross

The most important signal of the moving average convergence divergence is when the faster MA breaks the slower one. This gives us a signal that a trend might be emerging in the direction of the cross. Thus, traders often use this signal to enter new trades.

  1. Divergence

MACD also gives divergence signals. For example, if you see the price increasing and the indicator recording lower tops or bottoms, then you have a bearish divergence. Conversely, you have a bullish divergence when the price drops and the moving average convergence divergence produces higher tops or bottoms.

  1. Distance between MAs (overbought/oversold)

Since the indicator has no limit, many traders do not think of using the tool as an overbought/oversold indicator.

To identify when a stock has entered an overbought/oversold territory, look for a large distance between the fast and slow lines of the indicator.  The easiest way to identify this divergence is by looking at the height of the histograms on the chart.

This divergence often leads to sharp rallies counter to the primary trend.  These signals are visible on the chart as the cross made by the fast line will look like a teacup formation on the indicator.

5 Trading Strategies Using the MACD:

#1 – MACD + Relative Vigor Index

The basic idea behind combining these two tools is to match crossovers. In other words, if one of the indicators has a cross, we wait for a cross in the same direction by the other one. If this happens, we buy or sell the equity and hold our position until the moving average convergence divergence gives us signal to close the position. The below image illustrates this strategy:

This is the 60-minute chart of Citigroup from Dec 4-18, 2015. It shows two short and one long positions, which are opened after a crossover from the MACD and the RVI. These crossovers are highlighted with the green circles. Please note that the red circles on the MACD highlight where the position should have been closed. From these three positions, we gained a profit of $3.86 per share.

#2 – MACD + Money Flow Index

In this strategy, we will combine the crossover of the MACD with overbought/oversold signals produced by the money flow index (MFI). When the MFI gives us a signal for an overbought stock, we will wait for a bearish cross of the MACD lines. If this happens, we go short. It acts the same way in the opposite direction – oversold MFI reading and a bullish cross of the MACD lines generates a long signal.

Therefore, we stay with our position until the signal line of the MACD breaks the slower MA in the opposite direction. The below image illustrates this strategy:

This is the 10-minute chart of Bank of America from Oct 14-16, 2015. The first green circle highlights the moment when the MFI is signaling that BAC is oversold. 30 minutes later, the MACD has a bullish signal and we open our long position at the green circle highlighted on the MACD.

We hold our position until the MACD lines cross in a bearish direction as shown in the red circle on the MACD. This position brought us gains equal to $0.60 (60 cents) per share for about 6 hours of work.

#3 – MACD + TEMA

Here we will use the MACD indicator formula with the 50-period Triple Exponential Moving Average Index. We attempt to match an MACD crossover with a break of the price through the TEMA.

We will exit our positions whenever we receive contrary signals from both indicators. Although TEMA produces many signals, we use the moving average convergence divergence to filter these down to the ones with the highest probability of success. The image below gives an example of a successful MACD + TEMA signal:

This is the 10-minute chart of Twitter from Oct 30 – Nov 3, 2015. In the first green circle we have the moment when the price switches above the 50-period TEMA. The second green circle shows when the bullish TEMA signal is confirmed by the MACD. This is when we open our long position. The price goes up and in about 5 hours we get our first closing signal from the MACD. 20 minutes later, the price of Twitter breaks the 50-period TEMA in a bearish direction and we close our long position. This trade brought us a total profit of $0.75 (75 cents) per share.

#4 – MACD + TRIX indicator

This time, we are going to match crossovers of the moving average convergence divergence formula and when the TRIX indicator crosses the zero level. When we match these two signals, we will enter the market and await the stock price to start trending.

This strategy gives us two options for exiting the market, which we will now highlight:

  • Exiting the market when the MACD makes a cross in the opposite direction

This is the tighter and more secure exit strategy. We exit the market right after the MACD signal line breaks the slower MA in the opposite direction.

  • Exiting the market after the MACD makes a cross, followed by the TRIX breaking the zero line

This is the looser exit strategy. It is riskier, because in case of a change in the equity’s direction, we will be in the market until the zero line of the TRIX is broken. Since the TRIX is a lagging indicator, it might take a while until this happens.

At the end of the day, your trading style will determine which option best meets your requirements. Now look at this example, where I show the two cases