Moving Average Crossover and Stochastics Divergence Strategy

The moving average crossover trading strategy is one of the oldest and perhaps most widely used trading method when it comes to a trend following strategy. It works on the simply concept of averaging prices over a short term and a longer term time frame and is plotted as a continuous price. When a short term moving average price is higher than the longer term average price, it is viewed as being bullish and when the short term average prices are below the average longer term prices, the markets are known to be bearish.

There are many trading strategies that have been designed based on this simple concept, the most common being adding an oscillator to the mix. Buy and sell signals are generated based on the overbought and oversold levels signaled by the oscillator and taken in relation to how the short and longer term average prices are trending.

What most traders fail to grasp is the fact that when the concept of divergence is brought into the equation, the oscillators tend to be more powerful offering a much stronger and reliable buy/sell signals. If you, as a trader have attempted the various combinations and trading systems designed from the moving average trading system and have had little success, applying the concept of divergence, and more importantly the Stochastics divergence could help traders greatly benefit.

The Moving Average Stochastics Divergence strategy

For this trading strategy, we simply make use of two exponential moving averages; a short term and a longer term moving averages. A trader is free to choose the settings but we prefer to make use of a 55 period exponential moving average and a 21 period exponential moving average. Adding to the equation, we also make use of the Stochastics oscillator with the settings of 5, 3, 3 although it is up to the trader to experiment with various other settings as well. Once the above indicators are added to the charts, the trading system should look like the one below.

Moving Average, Stochastics Strategy – Buy/Sell

Once the chart is set up, it is essential to understand the order of the signals. A trader should first look to the Stochastics oscillator in order to spot divergences. Divergences are important because they signal the corrections in the trend and when this is applied to the moving averages itself, they can be a powerful combination. The following charts below signals the buy/sell signals based on the moving average and the Stochastics oscillator. For traders who are just reading this article, it is important to have a basic understanding of divergence which is explained in this article.

Sell Signals

1. The first step is to identify a bullish divergence on the Stochastics oscillator (prices make a lower low, Stochastics makes a higher low).
2. Once a bullish divergence is spotted, the next step is to look for the 21 EMA to be below the 55 EMA
3. The Sell signal is taken when the bullish divergence is completed and prices remain below the 55 EMA

MA, Stochastics Strategy – Sell Set up

In the chart above, we notice the bullish divergence that was formed, which triggers the initial alert to a potential short position. The entry of the short position comes at the lower low formed in price. With the 21 EMA below the 55 EMA it is a confirmation that prices are in the downtrend and when prices broke the divergence low, it signaled a short entry. The stops for this short set up comes at the high created by the divergence with targets taken at 1:1 risk reward followed by 1:2 risk reward.

Buy Signals

1. Identify a bearish divergence on the charts and the Stochastics oscillator (price makes a higher high and Stochastics makes a lower high).
2. After the bearish divergence is confirmed, look to the 21 EMA remaining above the 55 EMA
3. The buy signal is taken when prices complete the divergence and the moving averages confirm the trend as well.

MA, Stochastics Strategy – Buy Set up

In the above buy set up example, we notice a bearish divergence with prices making a higher high while the Stochastics oscillator made a lower high. Upon correction of the divergence and with the 21 EMA above the 55 EMA, a long entry would be taken at the higher high of the divergence with stops at the lower high where prices corrected. For the target, a 1:1 and 1:2 RR is applied.

Moving Average, Stochastics Strategy – Pros and Cons

The above strategy is rather simple once the reader has an understanding of how divergences work. By combining the moving averages, trading with the divergence offers traders a safe entry into the trade depending on the prevailing trend in the markets. While the above strategy is not failsafe, it offers traders a higher level of confidence based on the fact that this is in fact a trend following strategy where entries and stops are based on the corrections in price by means of the divergence.