EMA – Stochastics Filter Forex Trading Strategy

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EMA – Stochastics Filter Forex Trading Strategy

Trading strategies could often be classified into two categories – momentum strategies and mean reversion strategies. Momentum trading strategies often put more importance on the direction of the trend and the force of the trend. The concept behind momentum strategies being that if price has too much force going in one direction, then chances are it should continue going the same direction and betting that price would continue on for a few more pips is a safe bet. In a sense, this is true. Momentum strategies have the odds stacked in their favor. However, momentum strategies do have an Achille’s heel. Its weakness being that often looking for momentum trades live you with currency pairs or instruments that are either overbought or oversold. During these scenarios, momentum setups often get trapped as the market reverses. Which leads us to the opposite category of trading strategies – Mean Reversion.

Mean reversion strategies are strategies that put much more consideration on the level of price, whether it is overbought or oversold. As the name implies, mean reversion strategies believe that price would always go back to the average price, or its mean. If you’ve been looking at charts for quite some time, especially on the forex market, you would notice that this is true. Price does come back to its mean. This is also a logical way to trade as you wouldn’t want to be buying into a market which is already overbought or selling in a market that is already oversold. Its hard to sell high when you already bought high, and it is also hard to sell lower when you’ve already sold at a low price.

Some traders try to marry the two types of strategies – momentum and mean reversion. Many have proven their strategies and have gone on to become professional traders for hedge funds.

The strategy we will be discussing right now is the type of strategy that could be considered as a mean reversion strategy. However, even though it is a mean reversion strategy, we will also be taking into account the direction of the long-term trend.

To have a logical bias as to the direction of the trend, we will be using the 200 Exponential Moving Average (EMA). This is because the 200 EMA is a moving average that many traders look at. The more traders use it, the more reliable it is. Also, since overbought and oversold conditions, or mean reversion strategies, as a whole, are mostly extreme market conditions we would be needing to look at the longer-term direction of the trend, rather than the short-term to allow for signal to take place. Having an overbought or oversold condition coincide with a very short-term trend direction are only very few.

Traders also often use oscillating indicators to assess whether the market is overbought or oversold. In fact, it is quite difficult to assess whether price is overbought or oversold without one, with the exception of ranging markets with clearly defined horizontal supports and resistances, which are hard to come by.

One of the most common oscillating indicators used for mean reversion strategies is the stochastic indicator. I’d consider it as a faster moving oscillating indicator compared to the others. This allows us to trade the short-term mean reversions as price retraces back to the mean.

 

The Setup: The 200 EMA – Stochastic Oscillator Setups

Buy Setup:

  • Price should be above the 200 EMA signifying that the long-term direction bias is bullish
  • Allow the stochastic oscillator to go below the 20-level signifying oversold conditions
  • Wait for the main stochastic indicator line (solid line) to pierce the signal stochastic indicator line (broken line) going up
  • Enter the trade at the close of the signal candle

Stop Loss: A few pips below the fractal formed by the initial up-thrust of price.

Exit: Close the trade as the stochastics lines reaches the 70-level.

Sell Setup:

  • Price should be below the 200 EMA signifying that the long-term direction bias is bearish
  • Allow the stochastic oscillator to go above the 80-level signifying overbought conditions
  • Wait for the main stochastic indicator line (solid line) to pierce the signal stochastic indicator line (broken line) going down
  • Enter the trade at the close of the signal candle

Stop Loss: A few pips above the fractal formed by the initial down-thrust of price.

Exit: Close the trade as the stochastics lines reaches the 30-level.

Warning on Reverse Pressures

Like all strategies, this strategy is also not perfect. There are scenarios wherein this strategy doesn’t work and that is when the market decides to change trend direction. Often times, coming from a trending scenario, as the market decides to change directions, price would cross the 200 EMA with strong force. This is often accompanied by the stochastic indicator going to the overbought or oversold levels, which are our signal setups. However, you would notice that price would continue going the same direction and the mean reversion signal generated by the stochastic indicator is only a short thrust in price going our direction, before it continues crossing the 200 EMA. This scenario is exactly where our setup wouldn’t work. To avoid this, it would help going to the higher timeframes, sometimes you would find that what may be oversold in the lower timeframe is actually overbought in the higher timeframe. Below is an example of a setup that didn’t work on the 5-minute chart.

And below is the corresponding chart on 1-hour timeframe, showing that what is oversold on the 5-minute chart was actually overbought on the 1-hour chart.

Conclusion

If you are looking to be a mean reversion trader, this is a great place to start. Many of old school successful traders found the stochastic indicator to be such an effective tool for short term mean reversals. This was one of the tools used by Joe DiNapoli, a very successful trader, who pioneered the use of stochastics, MACD, Fibonacci levels, and more. You could even further your research on this with his book, DiNapoli Levels.

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