Trading with Stochastics
A Wealth of Knowledge
Stochastics oscillator is a momentum indicator that measures price range in the market. The indicator comes with default settings which are as follows: 5, 3, 3 as originally invented by George Lane (pic.1). It uses two lines that look like Moving Averages a blue line and a red dotted line. Where a blue line is referred to as the fastK period, which is then considered to be sensitive to price changes. The red (dotted) line on this indicator is called the D slow period which reacts slower to price changes relatively speaking. Furthermore, this indicator has a fixed minimum of 0 and a fixed maximum of 100, meaning whatever the move in the markets it will be measured from 0 to 100 in terms of the indicator and cannot go further than these fixed denominations. The indicator uses overbought and oversold signals to inform traders of the current state of price using an 80 and a 20 parameters which come preset to the indicator (pic.2).
A reading above 80 is regarded as overbought, meaning that the price is overvalued, overpriced and one should expect a correction of that move, depending on the set up this could be a signal that the trend is yet to change or reverse. However as one uses this indicator, they will notice that the indicator can stay oversold or overbought for long periods of time. It is for this reason why emphasis will not be placed on the stochastics crossover strategy. However just to give readers an idea of what is meant by this, this will be explained but not in depth for the reason that it is not a high probability set up and also to uphold the mission of this website which is to teach people what really works, the skills used by profitable traders and not what we had read about, but the principles which we use in the markets to this day and had proved to work over sustained periods of time. That is why cross over strategy is not a good strategy especially for someone who is starting out as a trader. Now that one understands the improbable nature of this system, then what is it?
Stochastics crossover signals aren’t necessarily overbought or oversold signals, it is when one makes a trade purely based on whatever analysis they had done and not necessarily wait for an overbought or oversold. A simple cross of both the stochastics lines would indicate a change in the trend and therefore one would place a trade on that regard (pic.3). It is highly advisable that one tries this out and see how this works out, like any other strategies for that matter. It is somewhat not a high probability trading strategy, especially during high volatility, and when the market is choppy so to speak. It works well in trending markets. To emphasize this, look at the illustration below, however one can use it with the overall trend of the market. Bullish crossover in an uptrend and a bearish crossover in a downtrend. one must be warned that it is not a good strategy especially when starting out. crossover's do not always mean the trend will change, stochastics lines may still reverse. it is for this reason that one should preferably trade the overbought and oversold set ups as they are more potent. Then again, the market may stay oversold or overbought for a long period of time. It is for this reason that a lot of beginner traders loose what potentially could have been a good trade. It is because they do not know how to use price action correctly and indicators. Indicators do work, only depending on how you use them, but the best indicator is the price itself. Study the charts correctly.
So now that you understand Different candlestick patterns and the whole concept of Support and Resistance. Using both that knowledge with stochastics can make up good trading strategy. Now stochastics does not replace normal chart analysis. So one does the normal analysis, to determine firstly the trend, uptrend or downtrend? Where is the market currently heading? After concluding what trend it is, all from using price action. That is support, resistance, trendlines, candlestick patterns, and the overall market structure. One ought’s to find out where support and resistance are, now obviously in an uptrend one should look for support. The opposite is true, in a downtrend look for a resistance. Now wait for the market to reach these areas of interests, then if it does reach these zones then the next steps is to look at the candlesticks. Trend reversal candlestick patterns that is, for instance a hammer, or a shooting star. Now that the trade has met all these criterions, the last but not least thing one can do they can look at the stochastics for confirmation. In an uptrend one should look to enter when the market is oversold, meaning it’s undervalued, underpriced, and therefore can go higher and should go higher. In a downtrend one is to look for an overbought signal which means the market is being overvalued, overpriced, therefore enter when the bears are yet to push the price down. Now one would see that stochastics was the last thing one looked at and not the first thing, the final trading decision was made upon making chart analysis and using an indicator to compliment the overall analysis. Now this may sound complicated but it is not as complicated as it sounds, in fact examples had been prepared as to illustrate how everything should come together.
Trend is your friend!
Firstly identify the trend. The overall trend is where the money is, as many would say. So everything one does, it should be in accord with the trend. How do we differentiate trends? In an uptrend the market the market makes higher highs and higher lows. In a downtrend it makes lower lows and lower highs just as depicted on these two pictures.
Using this analogy we determine the trend of the markets. For it is when we know trend that we know in which direction we want to trade in. so in an uptrend we are bulls, and in a downtrend we are bears simple as that. Secondly come support, resistance and trendlines. This is where much of the trading is done. Therefore this is where we look to enter. Either at support in an uptrend or at resistance in a downtrend. Sometimes trendlines can act support and resistance, so should the market touch such an area. Chances are, it will reverse into the direction of the trend pre retracement. When the market reaches either one of these zones, depending on the trend direction then comes third step. Candlestick patterns, traders look closely at closed candles. Candles have to close first before they can be considered, open candles do not mean anything until they have closed. Particularly, one should look for either a hammer or a shooting star. Click here to learn about different candlesticks patterns. When all is done, comes the stochastics overbought and oversold signals. Anything else is just not good enough. So when the stochastics is oversold or overbought, one should wait for those two periods to exit the overbought/oversold zones. Which are both the 20 and the 80 zones/parameters on the indicator. Now this is how it all comes together, study the picture below to discern what is being meant, or how does one apply these concepts on a live market.
Now this trading strategy is a low probability set up. Meaning not a lot of good trades come out of this strategy. Just as good as the stochastics crossover strategy. Taking trades the two periods cross. I will not dwell on this strategy because of the same reasons. Low probability set ups are a waste of time and I believe the reason one is here is so they could learn how to make money. Therefore learning low probability set ups is not a good place to start. Briefly though, stochastics divergence is when the stochastics is not in congruence with the price. Meaning the stochastics is not agreeing with the price, doing something else, something different from what the price is doing. So traders instead of following price, traders follow the indicator. They place a in the direction of the indicator. Say price is making higher highs and the indicator is making lower highs. This is a bearish signal, and the opposite is true. So upon seeing this, traders will then place a sell trade although price appears to be moving up. This is called a divergence trade. Trading in accord with the indicator, well stochastics in this case. But there are many other indicators that offer the same signal e.g. MACD, RSI and CCI indicators. In fact all these give better divergence signals than the stochastics oscillator, stochastics is a good at overbought and oversold signals which is what you should use it for.
How it comes together?
Now if you study the picture you will find that a trend was firstly determined, then resistance, followed by candlesticks pattern, then lastly stochastics overbought, in that order. So now one has a total of four reasons why they would take a trade, also called a trade criteria. Which refers to all the merits the trade should have in order for one to even consider a trade. A consistent application of this methodology, will enable one to gain skill. Remember, repetition is the mother of skill. Therefore, it is nothing but the consistent application of such rules that makes trading systematic and decreases human emotions from coming into play to fiddle one’s judgement. Sticking to rules will ensure that one’s approach is objective and not subjective. Check out trading psychology, to better understand what role can emotions play in one’s trading. Sometimes it is overlooked, though it is an integral part of trading, if you master your emotions, your system will do the rest.