Stochastic (ii)

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Previous...  Stochastic

Overbought and Oversold Stochastic 20/80 Signals

In a Range

Traders may use the stochastic to trade overbought and oversold levels. The buy signal is highlighted when the %K line breaks back across the 20 line to the upside and a short or sell signal is highlighted to us when the %k line breaks back across the 80 line to the downside. As with all trading strategies one of the ways to reduce false signals is to use the Stochastic with other indicators, chart patterns and support & resistance. But on a basic level we can see the stochastic at work in the below chart of FTSE. 

The FTSE has been trading horizontally and from Feb 11 to Aug 11 there has been 5 stochastic buy signals and 4 sell/short signals (where the yellow K line crosses the 20 & 80 lines). All would have made long run gains except for 1, 2 & 3 where there was a certain amount of whipsaw. Notice that the stochastic can remain above and below 80 and 20 respectively for a long period, so wait until the signal cross to confirm buy and short/sell positions. 

FTSE 100 - Using Stochastic Overbought and Oversold signals in a Range

Stochastic Range Trade (simple swing trade strategy):
  • General Parameters: set to a 12 period "slow" Stochastic on a daily chart
  • Buy trigger - Enter the trade long (buy) when Stochastic crosses above 20 (A on our FTSE example.)
  • Sell Trigger - Sell when Stochastic crosses above 80 (B)
  • Our stop/loss is placed just below support or resistance channel lines (C), or other strong levels 
  • Risk Reward Ratio: Generally swing traders look for 2:1 or 3:1. Calculate the loss you can take (generally no more than 2% of your total portfolio) and decide whether potential profit and stop/loss fit into this trading strategy.
  • The Opposite applies for shorting a trade - i.e. short on the 80 cross and sell the short on the 20 cross
All the stochastic parameters can be changed to meet your trading strategy.  For instance a longer term trader may use a 12 to 20 day period K, while a short term trader may use a 5 to 10 period K on an hourly chart to execute trades.  In fact the short term trader will probably use the longer-term strategy to establish trading areas, then drill down with a more sensitive Stochastic to pin point exact trading levels. The actual overbought and oversold levels can also be changed.  Some traders will use a 30 and 70 level in a less volatile market, so watch out for volatility when setting parameters.  

In a Trend

When the market is in a strong trend false signals can sometimes occur against the trend, while overbought and sold positions can stay for long periods when following the trend. It is therefore, important to identify the bigger trend and trade in the direction of this "Primary" trend. Look for oversold readings in an up trend and ignore frequent overbought readings. Similarly, look for overbought readings in a strong downtrend and ignore frequent oversold readings. Trading in the direction of the trend improves odds. 

In a trend the full stochastic's parameters may need to be changed.  For Instance a 14,3,3 Slow stochastic may never cross oversold levels in a strong up trend, so changing it to a 5,3%K 3%D may be necessary.  This in effect changes the look back period from 14 to 5 making it more responsive, loosening the signals.  It must be noted that stochastic signals going with the strong trend will be limited compared to those against, but these are the only ones to trade.  In general traders trade with the trend.  In our S&P 500 example below, we're using a 5, 3, 3 slow stochastic.

The shape of a Stochastic bottom gives some indication of the ensuing rally. A narrow bottom that is not very deep indicates that bears are weak and that the following rally should be strong. A broad, deep bottom signals that bears are strong and that the rally should be weak. The same applies to Stochastic tops. Narrow tops indicate that the bulls are weak and that the correction is likely to be severe. High, wide tops indicate that bulls are strong and the correction is likely to be weak.  This stochastic shape can be seen in our below S&P 500 chart example.  Look how the oversold areas are sharp and narrow in nature and the overbought are flatter and more numerous.  This is typical in an up trend.

S&P 500 - Using Stochastic Overbought and Oversold signals in a Trend

Stochastic Trend Trade (simple strategy):
  • General Parameters: set to a 5 period "slow" Stochastic on a daily chart
  • This is an Up-trend Trade.
  • Buy trigger - Enter the trade long (buy) when Stochastic crosses above 20 (A S&P Eg.)
  • Sell Trigger - Use a trending indicator to exit.  In our example we're exiting when price drops below a 50-day SMA, which has acted as support.  Our Exit would have been at (B).  Some traders may use a trending indicator like ATR and pin point an exact trade exit level.
  • Our stop/loss is placed just below strong support at(C).  In this case just under 50-day SMA 
  • Set up a trailing stop just under the trend support line (in this case just below the 50-day SMA)
  • Reward to Risk Ratio: Generally longer term traders look for upwards of 3:1. Calculate the loss you can take (generally no more than 2% of your total portfolio) and decide whether potential profit and stop/loss fit into this trading strategy. In this case it's wise to wait until the trend retraces to the support line prior to trading (as per or example).
  • The Opposite applies for shorting a trade - i.e. short on the 80 cross and sell the short on the 20 cross - only in a down trend
Obviously other indicators need to be utilised here, like volume to re-confirm a trade.  This is a simple set up, and we're using a daily chart to trade.  To place the exact trade, traders may drill down to an hourly trade to pick exact trading points.

Using Fast Stochastic to Trade

If using the fast stochastic in the two above examples, we would see many more signal crossovers. This can be a problem, as many of the signals will be false.  Traders get round this by using the slow version. However, they can trade on the fast if it has another confirmation point.  This confirmation is when the fast crosses the 50 line. For example if the fast stochastic crosses out of overbought or oversold AND crosses the 50 line - This 50 crossover is now the trade signal.  This is very similar to trading Williams %R.  

You can also use the fast stochastic %D line to trade.  It can work exactly like the above paragraph, just substitute the fast stochastic with the %D moving average.  There are many more ways to trade the fast stochastic, which we won't delve into here.  Many trading set ups will use different stochastic parameters to suit a particular strategy.  Experimentation is therefore needed.

Stochastic Crossover Signals

The %K line is the faster of the two lines drawn on the stochastic indicator. When the %K line crosses above the %D line then this can be a signal to buy and when the %K crosses below the %D this can signal a sell/short. When these crossovers occur in the overbought and oversold areas they tend to happen prior to an overbought and oversold crossover. This strategy is a little more aggressive than the overbought/sold crossover as it tries to catch the reversal earlier. It’s therefore more prone to false signals, so use with caution and with other indicators. 

In our chart below of EUR/USD we’ve drawn all the crossover signal points with a full, slow 12-period & 5-period stochastic.  Look how many signals there are.  In the EUR/USD chart we can see an upward trend turns into a range/slight downward trend. During this upward trend the 12 period stochastic was oscillating relatively high, which indeed indicates a strong upward trend. In this situation a trader will not go against the trend.  He/She will buy, as the gains on buying are more probable and predictable. The chart then ranges (indicated by 50-day MA) and the stochastic oscillates between overbought and oversold frequently. In a ranging market %K and %D crossover signals are stronger.

EUR/USD - Stochastic Crossover

Indeed, the crossover signals are stronger if they are in overbought and sold areas, so in general only trade when the crossover is in these areas, but remember don't use signals against the trend.  As mentioned earlier, changing the slow stochastic to 5, 3, 3 may be necessary if the market is trending.  As we can see from our example chart the 12-period oscillates high in a trend indicating momentum is on the high side.  A 5-period allows us to use crossover signals to trade. In our example they don't quite reach the 20 oversold area, but they have passed 30 at points (1) and (2).  As explained previously 30/70 is sometimes traded rather than 20/80. Trading a range or trend is the same as above in "Overbought and Oversold Stochastic 20/80".  Instead of trading on the 20/80 line crossover, trade on the stochastic and signal crossover while in the overbought and sold areas.

The indicator can also be used to identify support or resistance areas. Should a market trade near support with an oversold Stochastic Oscillator, look for a break above 20 to signal an upturn and successful support test. Conversely, should a security trade near resistance with an overbought Stochastic Oscillator, look for a break below 80 to signal a downturn and resistance failure.

Stochastic Divergence and Convergence - The Reversal

The stochastic divergence and convergence work very similarly to RSI divergence and convergence. When the stochastic trends in the opposite direction to price this is seen as a good indicator that the price momentum may reverse, as trader interest either wanes or increases. In our FX pairing chart below EUR/USD we  have a bullish convergence and a bearish divergence.  On the right we can see the divergence caused by decreasing upward price momentum – The price still goes up, but the momentum is turning. This divergence points towards waning upward momentum - a down turn is possible.

EUR/USD - Stochastic Convergence and Divergence

The chart also shows a convergence of the stochastic oscillator and price. The Oscillator is making higher lows, while the price is making lower lows. There is less downside momentum and the stochastic is showing this - a reversal or retracement maybe about to happen. 

These divergences and convergences along with oversold and overbought signals are a double confirmation to trade the reversal. Position (1) and (2) look like good trade points, buying at (1) and shorting at (2). As for trading the divergence and convergence, just follow the above trading examples for a range trade in our overbought and oversold section. Some traders (reversal orientated traders in the main) may only act on signals that come with a divergence or convergence, it's all dependent on your trading strategy.

To Sum Up

The Stochastic is a standard component on any basic technical chart. The Stochastic focuses on the momentum underlying the security and is a great secondary measure to be used by traders. It is important to note that the Stochastic is not often used as the sole generation of buy-and-sell signals but used in conjunction with other indicators and chart patterns.  It is most used in range trading, where overbought and oversold levels are clear.  It can be used in trend trading, but parameters may have to be changed and remember trade with the trend.

As we've seen, we can set the indicators sensitivity. The sensitivity of the indicator determines how quickly the trader enters the move and how accurate these trading signals are. If the indicator is set to low sensitivity then you generate less false signals, but you may see the move too late.  Longer-term traders will use a larger period slow Stochastic. With high sensitivity you are more likely to catch the move into the trade, but you may generate false trading signals. For instance a swing trend trader (trading with a horizon of 4 to 5 days) may set the parameters to a 5-period Stochastic once they've drill down to an hourly chart from a daily chart. Good charting software will allow the parameters to be changed. 

Technical analysis is not an exact science and although these indicators can increase the probability of making the correct trade, many will go against you and large losses can be incurred. Your own trading strategy needs to be formed and hopefully you'll be on your way to achieving this on completion of this course.


=======

Previous...  Stochastic

Overbought and Oversold Stochastic 20/80 Signals

In a Range

Traders may use the stochastic to trade overbought and oversold levels. The buy signal is highlighted when the %K line breaks back across the 20 line to the upside and a short or sell signal is highlighted to us when the %k line breaks back across the 80 line to the downside. As with all trading strategies one of the ways to reduce false signals is to use the Stochastic with other indicators, chart patterns and support & resistance. But on a basic level we can see the stochastic at work in the below chart of FTSE. 

The FTSE has been trading horizontally and from Feb 11 to Aug 11 there has been 5 stochastic buy signals and 4 sell/short signals (where the yellow K line crosses the 20 & 80 lines). All would have made long run gains except for 1, 2 & 3 where there was a certain amount of whipsaw. Notice that the stochastic can remain above and below 80 and 20 respectively for a long period, so wait until the signal cross to confirm buy and short/sell positions. 

FTSE 100 - Using Stochastic Overbought and Oversold signals in a Range

Stochastic Range Trade (simple swing trade strategy):
  • General Parameters: set to a 12 period "slow" Stochastic on a daily chart
  • Buy trigger - Enter the trade long (buy) when Stochastic crosses above 20 (A on our FTSE example.)
  • Sell Trigger - Sell when Stochastic crosses above 80 (B)
  • Our stop/loss is placed just below support or resistance channel lines (C), or other strong levels 
  • Risk Reward Ratio: Generally swing traders look for 2:1 or 3:1. Calculate the loss you can take (generally no more than 2% of your total portfolio) and decide whether potential profit and stop/loss fit into this trading strategy.
  • The Opposite applies for shorting a trade - i.e. short on the 80 cross and sell the short on the 20 cross
All the stochastic parameters can be changed to meet your trading strategy.  For instance a longer term trader may use a 12 to 20 day period K, while a short term trader may use a 5 to 10 period K on an hourly chart to execute trades.  In fact the short term trader will probably use the longer-term strategy to establish trading areas, then drill down with a more sensitive Stochastic to pin point exact trading levels. The actual overbought and oversold levels can also be changed.  Some traders will use a 30 and 70 level in a less volatile market, so watch out for volatility when setting parameters.  

In a Trend

When the market is in a strong trend false signals can sometimes occur against the trend, while overbought and sold positions can stay for long periods when following the trend. It is therefore, important to identify the bigger trend and trade in the direction of this "Primary" trend. Look for oversold readings in an up trend and ignore frequent overbought readings. Similarly, look for overbought readings in a strong downtrend and ignore frequent oversold readings. Trading in the direction of the trend improves odds. 

In a trend the full stochastic's parameters may need to be changed.  For Instance a 14,3,3 Slow stochastic may never cross oversold levels in a strong up trend, so changing it to a 5,3%K 3%D may be necessary.  This in effect changes the look back period from 14 to 5 making it more responsive, loosening the signals.  It must be noted that stochastic signals going with the strong trend will be limited compared to those against, but these are the only ones to trade.  In general traders trade with the trend.  In our S&P 500 example below, we're using a 5, 3, 3 slow stochastic.

The shape of a Stochastic bottom gives some indication of the ensuing rally. A narrow bottom that is not very deep indicates that bears are weak and that the following rally should be strong. A broad, deep bottom signals that bears are strong and that the rally should be weak. The same applies to Stochastic tops. Narrow tops indicate that the bulls are weak and that the correction is likely to be severe. High, wide tops indicate that bulls are strong and the correction is likely to be weak.  This stochastic shape can be seen in our below S&P 500 chart example.  Look how the oversold areas are sharp and narrow in nature and the overbought are flatter and more numerous.  This is typical in an up trend.

S&P 500 - Using Stochastic Overbought and Oversold signals in a Trend

Stochastic Trend Trade (simple strategy):
  • General Parameters: set to a 5 period "slow" Stochastic on a daily chart
  • This is an Up-trend Trade.
  • Buy trigger - Enter the trade long (buy) when Stochastic crosses above 20 (A S&P Eg.)
  • Sell Trigger - Use a trending indicator to exit.  In our example we're exiting when price drops below a 50-day SMA, which has acted as support.  Our Exit would have been at (B).  Some traders may use a trending indicator like ATR and pin point an exact trade exit level.
  • Our stop/loss is placed just below strong support at(C).  In this case just under 50-day SMA 
  • Set up a trailing stop just under the trend support line (in this case just below the 50-day SMA)
  • Reward to Risk Ratio: Generally longer term traders look for upwards of 3:1. Calculate the loss you can take (generally no more than 2% of your total portfolio) and decide whether potential profit and stop/loss fit into this trading strategy. In this case it's wise to wait until the trend retraces to the support line prior to trading (as per or example).
  • The Opposite applies for shorting a trade - i.e. short on the 80 cross and sell the short on the 20 cross - only in a down trend
Obviously other indicators need to be utilised here, like volume to re-confirm a trade.  This is a simple set up, and we're using a daily chart to trade.  To place the exact trade, traders may drill down to an hourly trade to pick exact trading points.

Using Fast Stochastic to Trade

If using the fast stochastic in the two above examples, we would see many more signal crossovers. This can be a problem, as many of the signals will be false.  Traders get round this by using the slow version. However, they can trade on the fast if it has another confirmation point.  This confirmation is when the fast crosses the 50 line. For example if the fast stochastic crosses out of overbought or oversold AND crosses the 50 line - This 50 crossover is now the trade signal.  This is very similar to trading Williams %R.  

You can also use the fast stochastic %D line to trade.  It can work exactly like the above paragraph, just substitute the fast stochastic with the %D moving average.  There are many more ways to trade the fast stochastic, which we won't delve into here.  Many trading set ups will use different stochastic parameters to suit a particular strategy.  Experimentation is therefore needed.

Stochastic Crossover Signals

The %K line is the faster of the two lines drawn on the stochastic indicator. When the %K line crosses above the %D line then this can be a signal to buy and when the %K crosses below the %D this can signal a sell/short. When these crossovers occur in the overbought and oversold areas they tend to happen prior to an overbought and oversold crossover. This strategy is a little more aggressive than the overbought/sold crossover as it tries to catch the reversal earlier. It’s therefore more prone to false signals, so use with caution and with other indicators. 

In our chart below of EUR/USD we’ve drawn all the crossover signal points with a full, slow 12-period & 5-period stochastic.  Look how many signals there are.  In the EUR/USD chart we can see an upward trend turns into a range/slight downward trend. During this upward trend the 12 period stochastic was oscillating relatively high, which indeed indicates a strong upward trend. In this situation a trader will not go against the trend.  He/She will buy, as the gains on buying are more probable and predictable. The chart then ranges (indicated by 50-day MA) and the stochastic oscillates between overbought and oversold frequently. In a ranging market %K and %D crossover signals are stronger.

EUR/USD - Stochastic Crossover

Indeed, the crossover signals are stronger if they are in overbought and sold areas, so in general only trade when the crossover is in these areas, but remember don't use signals against the trend.  As mentioned earlier, changing the slow stochastic to 5, 3, 3 may be necessary if the market is trending.  As we can see from our example chart the 12-period oscillates high in a trend indicating momentum is on the high side.  A 5-period allows us to use crossover signals to trade. In our example they don't quite reach the 20 oversold area, but they have passed 30 at points (1) and (2).  As explained previously 30/70 is sometimes traded rather than 20/80. Trading a range or trend is the same as above in "Overbought and Oversold Stochastic 20/80".  Instead of trading on the 20/80 line crossover, trade on the stochastic and signal crossover while in the overbought and sold areas.

The indicator can also be used to identify support or resistance areas. Should a market trade near support with an oversold Stochastic Oscillator, look for a break above 20 to signal an upturn and successful support test. Conversely, should a security trade near resistance with an overbought Stochastic Oscillator, look for a break below 80 to signal a downturn and resistance failure.

Stochastic Divergence and Convergence - The Reversal

The stochastic divergence and convergence work very similarly to RSI divergence and convergence. When the stochastic trends in the opposite direction to price this is seen as a good indicator that the price momentum may reverse, as trader interest either wanes or increases. In our FX pairing chart below EUR/USD we  have a bullish convergence and a bearish divergence.  On the right we can see the divergence caused by decreasing upward price momentum – The price still goes up, but the momentum is turning. This divergence points towards waning upward momentum - a down turn is possible.

EUR/USD - Stochastic Convergence and Divergence

The chart also shows a convergence of the stochastic oscillator and price. The Oscillator is making higher lows, while the price is making lower lows. There is less downside momentum and the stochastic is showing this - a reversal or retracement maybe about to happen. 

These divergences and convergences along with oversold and overbought signals are a double confirmation to trade the reversal. Position (1) and (2) look like good trade points, buying at (1) and shorting at (2). As for trading the divergence and convergence, just follow the above trading examples for a range trade in our overbought and oversold section. Some traders (reversal orientated traders in the main) may only act on signals that come with a divergence or convergence, it's all dependent on your trading strategy.

To Sum Up

The Stochastic is a standard component on any basic technical chart. The Stochastic focuses on the momentum underlying the security and is a great secondary measure to be used by traders. It is important to note that the Stochastic is not often used as the sole generation of buy-and-sell signals but used in conjunction with other indicators and chart patterns.  It is most used in range trading, where overbought and oversold levels are clear.  It can be used in trend trading, but parameters may have to be changed and remember trade with the trend.

As we've seen, we can set the indicators sensitivity. The sensitivity of the indicator determines how quickly the trader enters the move and how accurate these trading signals are. If the indicator is set to low sensitivity then you generate less false signals, but you may see the move too late.  Longer-term traders will use a larger period slow Stochastic. With high sensitivity you are more likely to catch the move into the trade, but you may generate false trading signals. For instance a swing trend trader (trading with a horizon of 4 to 5 days) may set the parameters to a 5-period Stochastic once they've drill down to an hourly chart from a daily chart. Good charting software will allow the parameters to be changed. 

Technical analysis is not an exact science and although these indicators can increase the probability of making the correct trade, many will go against you and large losses can be incurred. Your own trading strategy needs to be formed and hopefully you'll be on your way to achieving this on completion of this course.


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