Trading in the financial markets requires a blend of intuition, analysis, and well-tested strategies. This article delves into three of the top trading strategies that offer valuable insights to traders of all experience levels. We’ll break down their specific components, entries and exits and explain why they work for stock market trading and trading in other markets.
RSI + MACD Divergence
The RSI (Relative Strength Index) and MACD (Moving Average Convergence Divergence) are two common indicators featured in many day trading guides, known for their ability to help traders identify price changes in fast-moving markets. Both the RSI and MACD are used to gauge the momentum of a trend, but when they diverge from the actual price movement, it's often an early warning sign that a reversal may be due soon.
- Divergence in RSI and MACD: For a bullish divergence, the price makes a lower low while the RSI and MACD make higher lows. Conversely, for a bearish divergence, the price makes a higher high while the RSI and MACD make lower highs.
- RSI movement: An entry signal is given when the RSI crosses above 30 (indicative of potential upward momentum) or dips below 70 (suggesting possible downward momentum).
- For a bullish divergence: Traders will often place a stop loss slightly below the recent swing low or a support level.
- For a bearish divergence: It's typical to set the stop loss just above the recent swing high or a resistance level.
- Traders may consider closing their position when there's a shift in the momentum indicated by either the RSI moving back to the 50 level or the MACD line crossing its signal line.
Why Does This Strategy Work?
When both RSI and MACD show divergence with the price, it's like having two witnesses corroborating the same story. Divergence in these indicators often suggests that the prevailing momentum behind a price trend is weakening. This weakening momentum, coupled with other market factors, can lead to a trend reversal.
By entering a trade when the RSI dips below 70 or rises above 30, traders are attempting to catch the initial phase of a potential trend reversal, capitalising on the early momentum shift. The combined strength and validation from both indicators provide a more robust trading signal, reducing the likelihood of false entries and improving the probability of successful trades.
A Pullback to Support/Resistance
Understanding support and resistance levels is fundamental in technical analysis. These levels represent price points where the asset has historically faced buying or selling pressure, making them pivotal areas to watch.
When the price breaks through these levels and then retraces to test them, traders have an opportunity to capitalise on the market's attempt to reconfirm or challenge the breakout. This price action strategy is preferred by many for its simplicity and repeatability.
- After a bullish breakout: The price should retrace back to what was previously a resistance level. If this resistance-turned-support holds, it's an indication that the breakout is genuine and the price is likely to continue its upward trajectory.
- After a bearish breakout: The price should retrace to the former support level. If this support-turned-resistance holds, it suggests the breakout is valid, and the price may continue its decline.
- Following a bullish breakout: Traders often position the stop loss just below the new support level (formerly resistance) or an adjacent swing low to safeguard against false breakouts.
- After a bearish breakout: The stop loss is typically set just above the new resistance level (formerly support) or a nearby swing high.
- As the price progresses away from the support or resistance level post-pullback, traders could eye subsequent support or resistance levels as potential areas to take profits.
Why Does This Strategy Work?
A pullback to support or resistance is essentially the market's way of reevaluating and confirming its initial breakout decision. If resistance is broken and then successfully tested as a new support, it underscores the market's bullish sentiment. Similarly, if a support level is breached and then reaffirmed as resistance, it underlines the bearish stance of the market.
This self-confirmation builds trust in the breakout's authenticity, allowing traders to join the trend with more confidence. As this dynamic unfolds, it attracts more participants, further fueling the trend's direction.
Stochastic + HMA
The combination of the Stochastic Oscillator and Hull Moving Average (HMA) offers a powerful toolset for traders. Let's briefly introduce both indicators before diving into the strategy.
- Stochastic Oscillator: A momentum indicator comparing a particular closing price of an asset to a range of its prices over a certain period. Levels above 80 typically indicate that the asset is overbought, while levels below 20 suggest it is oversold.
- Hull Moving Average (HMA): A type of moving average that responds faster to price changes than standard moving averages. It reduces lag and increases responsiveness, making it useful for short-term traders.
Note that this strategy works best when trades are taken in the direction of the overall trend.
- The Stochastic Oscillator should be either in overbought (>80) or oversold (<20) areas. Once the Stochastic moves back below 80 or rises above 20, it indicates a potential momentum shift.
- Subsequently, if the 9-period HMA (blue) crosses over the 21-period HMA (red) shortly after, this acts as a confirmation of a trend reversal. For an uptrend, the crossover of the 9-period HMA above the 21-period HMA confirms a buy signal at the close of the candle. Conversely, for a downtrend, the 9-period HMA crossing below the 21-period HMA confirms a sell signal.
- Traders often set the stop loss just above (for short positions) or below (for long positions) the nearby swing points to manage risk effectively.
- Traders employing the Stochastic + HMA strategy might look for signs of trend exhaustion or a reversal in the Stochastic Oscillator for clues to take profits.
- Additionally, monitoring subsequent crossing of the 9-period HMA back over the 21-period HMA in the opposite direction of the trade, or reaching a nearby support or resistance level, could serve as sensible points to lock in gains.
Why Does This Strategy Work?
The Stochastic oscillator's primary function is to identify overextended conditions in the market. Like all indicators used in isolation, it can provide false signals. However, when paired with the faster-reacting HMA, the Stochastic's early warning is confirmed by the HMA. The quick response of the 9-period HMA to price changes combined with the smoother, longer 21-period HMA gives traders a clear indication of short-term momentum shifts, increasing the likelihood of successful trades in fast-moving markets.
The Bottom Line
In summary, traders exploring various types of trading in the stock market can benefit from these strategies. Moreover, they’re not just limited to stocks; you’ll find the same repeatable trades across the forex, commodities, and crypto* markets. However, it’s vital to remember that the strategies are a framework that should be tailored to a specific trade.
The key to using them effectively is in continuous learning and practice. Once you’re ready to apply them for real, you can consider opening an FXOpen account. When you do, you’ll gain access to a diverse range of markets, competitive trading costs, and rapid execution speeds. Happy trading!
*At FXOpen UK and FXOpen AU, Cryptocurrency CFDs are only available for trading by those clients categorised as Professional clients under FCA Rules and Professional clients under ASIC Rules, respectively. They are not available for trading by Retail clients.
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