Combining Stochastic with other Indicators:

We will revisit the same EUR/GBP time period we examined on pages 3 and 4 (figures 4 and 5). To shed more light on the movements than jus the first interpretation we analyzed, we will add two indicators; another momentum oscillator, RSI, and a trend following indicator MACD-Line.

It is very useful to combine indicators, as a combination of signals is better than relying on only one indicator. They reinforce each other, or can cancel out false or iffy signs. A trend indicator helps a trader to see the overall picture, while using more than one momentum indicator can give better and more reliable entry and exit points for swing movements. For instance, someone only using RSI’s overbought/oversold levels would have missed some of the key turning points in the above EUR/GBP pair.

Of course, analyzing the movements is easier after the fact, but regardless, the indicators and their signals help to decipher a lot of the market activity (without even looking at fundamentals). After reading this article, one can check their graphs or the CMS archives to see what actually happened to this pair after (9) and continue the analysis.

The Euro vs US Dollar, End of 2005 to May 2006, on a daily graph.

1. As described before, the wide top on the Stochastic indicator, at the start 2006, implies that the next downward contraction should be weak. The wide top shows that even when the pair was considered overbought, above the 80% level, there was still sufficient buying pressure.

a) The MACD-Line indicator peaks at this time and starts a downtrend that lasts until February.

2. Three signals converge the start of February:

a) Stochastic dips below and above 20,
b) RSI stops heading down and reverses, and
c) MACD hits a trough.

This trough may not be obvious during the fact, but one must remember that MACD is a trend follower and that the decline from the start of MACD at (1) to here is rather large. The three indicators are giving Buy signals because they measure the pair to be oversold. The shape of the bottom suggests that bears are weak and bulls are strong. Know it or not, the pair is now in a trading range.

3. During a ranging market Stochastic will give the fastest (and in this case only) signals.

a) There are two Stochastics Sell signals; a turn back from the 80% and a %K and %D crossover.
b) MACD, true to form, is no help during a ranging market.
c) RSI had been climbing and reversed, (but at the time one might not have known that).

Following Stochastic, a technical trader would Sell speculating that price would head back down as it was poised to hit resistance with slackening buying pressure. From the narrow, shallow top the trader could believe that the contraction will be strong. In this ranging market, the contraction happens very quickly, mainly on the first day. Right after the Stochastic signals there is a Pound rally in one big, 60 pip, red candle. It is captured in the black box. Price heads a little lower in the beginning of March.