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Trading with the Flow Using Stochastics

Trading with the Flow Using Stochastics

David de Ferranti, Currency Analyst

Talking Points:

  • Stochastics can time an entry into a pull-back in the trend
  • A stochastic based trading strategy doubled a 10K account over 10-years
  • Join next week’s webinar for more performance tests

Want to trade with proprietary strategies developed by FXCM? Find out how here.

A trend in the FX market is like a flowing river. A river may face some bends, slowdowns or rapids along the way to the sea, but the river keeps flowing in the same direction. A trend can similarly have some pullbacks along its path, and these temporary deviations can represent opportunities for traders to jump in and ride out the underlying move.

There are several popular technical analysis tools for trying to time entries into a pull-back in the trend. One of the most popular, but often misused, tools is Fibonacci retracement levels, which can have a high success rate when used correctly. The stochastics indicator can also be helpful, as it provides straight forward and easy-to-read signals for entry and is less subjective than Fibonacci retracement levels.

In this week’s strategy webinar, we tested the performance of a trading strategy that uses the stochastics indicator to time the entry into an underlying trend. The system is a variation on the Swing Trading Trends with Stochastics strategy presented by DailyFX Trading Instructor James Stanley. The details and results are discussed below.

When do we buy and sell?

  • Buy if %K crosses above %D AND %K is less than 20 (oversold) AND price is greater than the 50 period simple moving average
  • Sell if %K crosses below %D AND%K is greater than 80 (overbought) AND price is less than the 50 period simple moving averag
  • The parameters were the ‘Traditional’ stochastics parameters (14,3,3), also known as ‘slow stochastics'
  • The strategy was tested on the 4 hour timeframe across 4 currency pairs over 10 years.
  • A USD 10,000 account was assumed with trade sizes of 10,000.

You can see a visual representation of when the strategy buys and sells below.

Sell

Buy

Trading_with_the_Flow_Using_Stochastics_body_Picture_4.png, Trading with the Flow Using Stochastics

AUD/USD, H4, Created using Marketscope 2.0

Results

The results below illustrate that the strategy almost doubled the size of the account for the GBP/USD and generated returns of roughly 50% for the AUD/USD and the EUR/USD over the period tested.

Trading_with_the_Flow_Using_Stochastics_body_Picture_3.png, Trading with the Flow Using Stochastics

We can compare the performance of this strategy with the performance of simpler stochastic systems. The charts below show how our trend trading stochastic strategy with the 50 SMA (labeled SMAFilter) compares to:

  1. A simple %K and %D crossover strategy (Pure Crossover)
  2. A %K and %D crossover strategy with a filter for overbought and oversold levels (OBoughtOsold)
Trading_with_the_Flow_Using_Stochastics_body_Chart_2.png, Trading with the Flow Using StochasticsTrading_with_the_Flow_Using_Stochastics_body_Chart_1.png, Trading with the Flow Using Stochastics

The comparisons above illustrate that the trend trading with stochastics system (SMAFilter) generated the most total profit over all pairs and was the only system that was profitable for the EUR/USD. It also had a better accuracy rate than the simple PureCrossover system.

Join next week’s trading strategy webinar for more performance tests and discussions on how to utilize popular indicators.

New to Forex? Watch this video

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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