MACD and Stochastic: A Double-Cross Strategy (2024)

Ask any technical trader and they will tell you the right indicator is needed to effectively determine a change of course in a stock'sprice patterns. However, anything one "right" indicator can do to help a trader, two compatible 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 anduse these indicators 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.

Working the Stochastic

The history of thestochastic oscillatoris filled withinconsistencies. Most financial resources identify George C. Lane, a technical analyst who studied stochastics after joining Investment Educators in 1954, as the creator of the stochastic oscillator. Lane, however, made conflicting statements about the invention of the stochastic oscillator. It's possiblethe then-head of Investment Educators, Ralph Dystant, or even an unknown relative from someone within the organization, created it.

A group of analysts most likelyinvented the oscillator between Lane's arrival at Investment Educators in 1954 and 1957, when Lane claimed the copyright for it.

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 andheads 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 trends 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.

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.

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,it is considered a bullish moving average crossover.

It's helpful to notethere 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.

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, bullishrefers 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 greater value than the nine-day EMA, also called the "MACD signal line."
• The stochastic's bullish divergence occurs when the %K value passes the %D, confirming a likely price turnaround.

Crossovers in Action: Genesee & Wyoming Inc.

Below is a historical example of how and when to use a stochastic and MACD double-cross.

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

You may noticea couple of instances when the MACD and the stochastics are close to crossing simultaneously:Jan. 2008, mid-March, and mid-April, for example—a notable time in the market. 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 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 you include crosses that occur within a wider time frameso you can capture moves like the ones shown below.

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. 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. Preferably, you want the histogram value to already be or move higher than zero within two days of placing your trade.

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

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

Special Considerations

The advantage of this strategy is it gives traders an opportunity to hold out for a better entry point on an up-trending stock or to be more sure 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.

With every advantage of any strategy present, there is always a disadvantage. 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.

The stochastic and MACD double-cross allows 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, then choose the number of days that work best for your trading style. You may also want to add arelative strength index(RSI) indicator into the mix, just for fun.

The Bottom Line

As a trader using technical analysis to make decisions, you can combine various indicators to get better results and beat your competitors. Pairing two of the most well-known indicators, MACD and the stochastic oscillator, should allow you to achieve better results than just using one of these.