Stochastic and RSI Strategy – a Reliable Forex Trend Trading Strategy
In this strategy post, we have put together a reliable Forex Trend Trading Strategy, the Stochastic and RSI Strategy. The Stochastic oscillator, as the RSI, is a normalized momentum indicator bounded by 0 – 100 limits. The Stochastic consists of two lines: %K, which measures the relative position of the current closing price in a range defined by the trader, and %D, a 3-day moving average of the %K line which is a signal line. When %K crosses %D upward or downward, then a change in the market trend is oncoming.
The Stochastic measures the momentum, comparing the most recent closing price to the absolute price range (top of the range – low of the range) over a period of n days. The practical application methods of the Stochastic in trading are different as for all oscillators, but, according to Lane, the inventor of this oscillator, the divergence with prices should be the most important factor in the investment choice. Let’s take for example the following AUDUSD chart to understand how even beginner traders can work at their best with the help of this oscillator.
The red line represents the 5-day %K, while the dashed black line represents the 3-period %D. For what concerns the divergence, or the alert to which the trader has to pay attention to obtain a Sell signal, we can immediately notice how this is registered compared to prices when %K starts to fall down with respect to prices that keep on rising (vice versa in case of a Buy signal). Here, however, we can add a further confirmation that will be able to support traders in their choice. In fact, when we are facing an overbought (or oversold) area and the stochastic implies the %K cutting %D, then we have an reversal signal, further reinforced when %D exits from the overbought (see blue vertical bars).
A third and final element of confirmation that the trend has changed, comes when %D (i.e., the slower line) cuts the neutral line of 50. In this case, we will lose a slice of movement, but the trader will have the certainty of the change of the trend. Obviously, the money management is of paramount importance and false signals such as those marked with X are neutralized with the stop loss placed above a significant previous top.
The RSI (or Relative Strength Index) is perhaps the most used oscillators by traders, thanks to its easy to read graphics and ease of understanding. The RSI, measured in 14 periods by its inventor Wilder, sets the bullish days against the bearish ones, indicating the speed in the price movement. When the overbought threshold (above 70) or the oversold threshold (below 30) is reached, we can consider the rise / fall speed of prices as excessive. We tend to sell quite superficially when the RSI is above 70 and buy under 30. This is a fatal error, a generator of numerous false signals. As with the Stochastic, there are two factors that should guide the choice of the trader: operate in the primary trend direction and wait for the creation of divergences between RSI and prices. We can quote another example: the below chart is on GBPJPY.
The cross is clearly in an upward trend and it suffers a first correction in July when the RSI enters the oversold area. GBPJPY starts to rise but suffers a new correction culminating with the low of September, still in oversold. While the lowest price of September is lower than that of July, the RSI indicates a divergence. Still setting appropriate stop loss levels, the trader may now want to be aggressive by immediately entering long, or waiting for the exit of the Rsi from the oversold zone while the price indicates a rising top compared to previous readings. Both these oscillators, Stochastic and RSI, have an explosive value if used in the direction of the main trend and when prices touch levels of significant support / resistance. Obviously, everything has always to be accompanied by strict money management plans.
The Stochastic and RSI Strategy is simple to implement and provides somewhat reliable buy/sell trading signals. However, it’s always best to use indicators on longer time frame like 1H or 4H. Another lower would probably give out more false signals.
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