Technical indicators - moving averages and stochastic oscillator
Technical indicators are a tool that sends you a signal about the possible direction of the trend, whether an instrument is too expensive and therefore its price could fall, or whether it is too cheap and therefore its price could rise, etc. Of course, you need to remember that all indicators are based on history, which means that they are somehow lagged. Nevertheless, they can be of some help to sort market data into groups and thus provide a clearer interpretation of the market situation.
Moving averages can be used to determine the direction of the oil trend. A stochastic oscillator can be used to determine whether oil is too expensive (and therefore overbought) or too cheap (and therefore oversold) within an identified trend. It is preferable to combine both of these indicators.
In chart 3 we have an example of using these indicators to trade oil on the H4 chart.
WTI crude oil on H4 chart with moving averages and stochastic oscillator
The moving averages are the EMA with a period of 50 (red line) and the SMA with a period of 100 (blue line). In the case when the faster average, i.e. EMA 50, falls below the slower SMA 100, it is a signal of a bearish, i.e. downtrend. Otherwise, when the faster average EMA 50 is above the SMA 100, then it is a signal for an uptrend.
In the case of an uptrend, we try to look for entries in the long direction. In the case of a downtrend, on the other hand, we try to look for trades in the short direction.
In the chart above, you can see that the SMA 100 moving average has acted as support in the case of an uptrend or as resistance in the case of a downtrend. If a trader chose an entry strategy after the SMA 100 is hit, he would have 4 trading situations, 2 trades long and 2 trades short.
At the same time, we can see that the stochastic indicator fell below 20 when oil reached the SMA 100 in an uptrend. And in the case of a downtrend, the stochastic reached above the 80 value when the price touched the SMA 100. From this, a trading strategy can then be built:
Enter long when the price on H4 is at SMA 100 and before that, the stochastic was at 20. Enter long when the first bullish candle is formed. Once this occurs, the entry is at the opening of the next candle.
Enter short when the price on H4 will be at SMA 100 and before that the stochastic was at 80. An entry short is when the first bearish candle forms, i.e. at the opening of the second candle.
Then the trader only deals with risk management and money management rules. In terms of take profit, it is advisable to set it to the nearest area of support and resistance, i.e. it is a mistake to speculate on a breakout of this area. The stop loss is then placed below the low of the given formation for long trades, and above the high of the formation for short trades.
We see that in the cases of trades 1, 3, and 4, the profit would always be at least 1:1 relative to the risk. And the maximum profit when taking into account the take profit to the nearest resistance or support areas would be approximately 2.5R in the case of trade 1, 2R for trade 2, and 3R for trade 3. Supposed the one R (the stop loss value) is 1% of the account balance, then the minimum profit would be 3% and the maximum profit would be approximately 7.5% for that trade in less than 3 months.
Situation number 2 should not be traded because it is a disadvantageous risk/reward ratio, as the take profit when set to the nearest resistance gives a lower profit than the risk taken.
Even though the above examples worked out reasonably well, there are bound to be situations where the strategy fails because the indicators give false signals as well as good ones. Therefore, it is a good idea to test situations in your platform yourself when the strategy does and does not work. At the same time, you need to think about what risk management rules to adopt so that the strategy makes sense in the overall context of not only good signals but also false ones.