In the last unit we looked at the RSI indicator which introduced another oscillator to your technical indicator arsenal. In this unit we will take you through a Stochastic Oscillator Introduction. It is very similar to RSI but many traders prefer to use this particular indicator instead.
The stochastic indicator helps determine when a market is overbought or oversold and checks if the buying or selling pressure is running out of steam, suggesting a reversal and this helps us time a trading opportunity. The best time to use this indicator is when you are in a trend and price has pulled back to support or has rallied up to resistance. Identifying the trend is easy, but identifying support and resistance can be a lot more difficult.
The Stochastic indicator is plotted using values between 0-100 with the value of 100 consider overbought, increasing the chance of a move to the downside and the value 0 is considered oversold with the probability of a rally much higher. 80 or high is overbought, 20 or below is oversold. You have an overbought and oversold region.
In a uptrend, you want to buy from the oversold level and in a downtrend you want to sell from the overbought zone.
As you are entering a trade AFTER the move, you can use the recent swing as your stop loss. A simple strategy is to wait for the K line to move across the slowing moving D line and then enter on the close of that candle.
The Basics of the Stochastic Indicator
Only trade in the direction of the market.
Similar to the MACD unit, the trend is your friend. I will repeat myself here; the basic premise of my personal trading which I recommend to anyone who is just starting out, is to follow a trend and only trade in the direction of the market. This is because prices can remain overbought or oversold for a prolonged period of time in trending moves. So we only look to buy in upward trend moves when it’s oversold and sell in downtrending moves when it’s overbought.
We are looking for signals when the two main components of the indicator cross over each other.
In the previous article we discussed the MACD crossover which involved two different averages combine to create one line and a third average is used to create signals.
With the Stochastic Oscillator the signal process and the decision making process is much the same as MACD. We are looking for signals when the two main components of the indicator cross over each other.
There are two types of Stochastic Oscillator
Well technically three but two of them are the most popularly used and most commonly available on charting platforms. The two types are FAST Stochastic, which is a more aggressive oscillator and the SLOW Stochastic, which is a more conservative oscillator. The SLOW stochastics provides less signals than the FAST stochastics, because it smooths out the data making it a lot more conservative and useful for traders looking to take up swing positions. The FAST Stochastic provides much more signals than the SLOW Stochastic, but the accuracy of signal is much lower, this is more useful for those trading short term or scalping.
Stochastic Indicator Settings
Most of the examples I have explained in this article have used a slow Stochastic indicator and settings of 15 5 5. The first number is the raw Stochastic value, the second number is the moving average of the first number and the third number is a moving average of the second number.
%k – the raw stochastic value
%D – moving average of %k
%D slowing – a moving average of %D
It’s basically a moving average of fast stochastic
Trading Stochastic Indicator Divergence
When trading with the Stochastic indicator you want to follow a certain process
- Choose your market identify the trend – if it’s bullish, only buy. If it’s bearish, only sell
- Identify the support and resistance levels and load up your choice of indicator
- Look for the signals you need, following a simple strategy, such as the one at the bottom of this article.
- Always be using protective stop losses.
- Use the chart to help you decide your stop loss level, use a previous high or low, depending on whether you are trading long or short.
- Work out how pips you are risking with your protective stop loss (these pips are your risk)
- Use a 2:1 reward to risk ratio, so double the pips you are risking from above, and set that as your target
The key concept behind many oscillators like the Stochastic indicator is that it provides buy and sell signals. To trade this indicator effectively you should do so with a 2:1 reward to risk ratio. This means risking half as much as you expect to gain.
You dont need to win each trade, because with a decent risk to reward strategy we only need to win 35-40% of trades to breakeven so money management is crucial on this strategy, always use stop loss and double it for the profit target.
Positive Divergence Examples
In these two examples, the markets are trending up and we have had a pullback to support.
The first example was a double trade. We entered the first trade just because it appeared oversold, but the trade failed and we were stopped out. This created positive divergence on the oscillator and we had the opportunity to go long again, which worked out very well. We lost the first trade, but the second got us back into profit.
The second example was much more straight forward. The market was in an uptrend. We had a pullback to major support (August 2015 low). The candle stick pattern suggested a bullish reversal, and to top it all off we had positive divergence on the oscillator. A brilliant trade setup and a profitable trade.
Negative Divergence Examples
These examples are the reverse of the positive divergence examples above. But the strategy is very similar and the rules are almost identical (in reverse).
The first example shows a double trade setup. The chart is for the German Dax and after reaching a major high, we shorted but were stopped out. After reaching the second high, we printed negative divergence and then sold off over 700 points. The second example shows the EURUSD which was in a downtrend. We rallied up to resistance at 1.25, printed negative divergence and then proceeding the shed around 800 pips. Great trade!
Trading the Stochastic POP
Once price breaks in to the overbought or oversold regions price will very often experience a “pop” like a corn kernel and price can continue to move in the direction of a trend. This is perhaps because many traders will automatically trade in the opposite direction and as a result prices continue to move the same way, or simply because the indicator is signalling strong momentum.
I won’t deliver too much information on this strategy, I will leave you to research it for yourself, but the pop strategy normally follows the daily trend, perhaps using a H4 or H1 chart with a slow stochastic of 15 5 5 so for example in an uptrend, the strategy would buy on the open of the next candle once prices gets into the overbought zone, as price pops higher. Or in a downtrend the strategy would sell once price reached the oversold zone as price pops lower.
Drawbacks to the Stochastic Indicator
Not as reliable as MACD in terms of accuracy of signal, it provides a high volume of signals in a timely fashion, but they are not always very accurate. The Stochastic indicator is not great as a stand alone indicator, because it often needs other forms of confirmation before you can rely on the quality of the signal.
To use the Stochastic indicator properly you need to have some ability reading charts and be comfortable plotting support and resistance; this is essential otherwise you will constantly receive false signals and never feel confident with your indicator.
Simple Stochastic Indicator Trading Strategy
Use a 200 period simple moving average on the daily chart to understand the underlying trend of your market.
Decide that you want to look for signals only in that direction
- The trend on the daily chart must be bullish
- Use a H1 chart or higher and apply a slow stochastic indicator 15,5,5
- The market must be in the oversold signal zone (20 or below)
- Once the Slow stochs are in the signal zone, look for a cross of the signal lines
- Once you have a cross, identify the most recent major low.
- Place a stop loss underneath there, go long and target 2x your stop loss.
- The trend on the daily chart must be bearish
- Go down to a H4 or a H1 chart and apply a slow stochastic indicator 15,5,5
- The market must be in the overbought signal zone (80 or above)
- Once the Slow stochs are in the signal zone, look for a cross of the signal lines
- Once you have a cross, identify the most recent major high.
- Place a stop loss above there, go short and target 2x your stop loss.