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Stochastics is another popular oscillator traders use to gauge price momentum and judge the age of a price move, like the Relative Strength Index (RSI). Stochastics is not a new oscillator.
Unlike the RSI, which measures momentum based on the changes in daily settlement prices, the stochastics oscillator has two lines and the calculations are based on the rate of change in the daily high, low, and close price. The concept for stochastics is based on the tendency that as prices move higher, the daily closing prices will be closer to the high of the daily price range. The opposite is true in downtrends. As prices decrease, the daily closes tend to accumulate closer to the lows of the daily trading range. This concept also holds true on daily, weekly as well as monthly charts.
Stochastics can be calculated for any time period. Choosing the right time period for the stochastics oscillator is similar to choosing the right number of days for a moving average. In effect, stochastics is a trend following technical analysis method since its lines will cross after tops and bottoms are already established. Choosing the time period too short will make the stochastics so sensitive that it becomes virtually worthless. If the time period is too long, it is too slow to turn and too insensitive to be useful.
Both bearish and bullish divergence are shown on the accompanying S&P chart below. You can see a bearish divergence in late February when S&P prices made a new high but the %D line stays far below its winter high. This divergence accurately warned traders and investors that a top was forming. An equally good signal of a bottom was the bullish divergence during the spring. The S&P was making new lows into early May, but the %D line held above the lows made during March:
Using Stochastics to find Overbought or Oversold zones
Markets seldom go straight in one direction without a pause or correction. When prices move up and appear to be ready to correct, the market is called overbought. When prices have been moving down and appear to be ready to rebound, the market is oversold. As a mathematical representation of a marketís overbought or oversold condition, stochastics tells you when prices have gone too far in one direction.
Values above 75 (in the shaded area) indicate the overbought zone. Values below 25 (also shaded) indicate the oversold zone. (Some traders prefer using 80 and 20 as the parameters for overbought and oversold markets.) In sustained moves, stochastics values may remain in these shaded areas for extended lengths of time.
Stochastics Buy / Sell signals
There are at least two popular ways traders use stochastics in order to find buy and sell signals. A conservative approach is to wait for both the %K and %D to come out of the shaded area to issue the trade signal. For sell signals, a conservative trader would wait for both lines to rise into the overbought zone and then fall below 75 again. An opposite pattern is followed for a buy signal. After both lines drop below 25, the buy signal is given when the stochastics lines climb above 25 again. This is a more conservative approach because you will be slower in taking a position, but it may eliminate some false signals.For more aggressive traders, the buy and sell signals on the stochastics charts are generated when the two lines cross. For most traders the buy and sell signals are flashed when %K crosses %D, as long as both lines have first gone into the overbought or oversold zones. This is similar to the buy and sell signals of two moving averages.
Waiting for the stochastics lines to come out of the shaded area will sometimes prevent you from false Ė signals. For example, If you, were looking for a buy signal on the stochastics chart for the NYSE composite index during the August to September period, %K crossed the %D line in early August and at least five more buy signals were given before the trend finally turned upward in early October. An aggressive trader who traded with the first crossing of the lines would have been stopped out at least a couple times before finally getting a good move up. A more conservative trader would have been waiting for both lines to climb out of the oversold area before buying, thus avoiding the whipsaw signals we got from August and September.
Oscillators tend to be notoriously unreliable in signaling trades against the trend. For good stochastics signals, you will need to trade with (and follow) the longer-term trend (The Giant Footprints). Follow only the buy signals in uptrends and only the sell signals in bear markets. However, in a range bound market, stochastics will give you good buy and sell signals.
Buy and sell signals are shown on S&P 500 chart. With stock indexes in an overall uptrending pattern, the stochastics buy signal would have helped traders establish long positions on the buy signals in November, December and March. The sell signals in February, June and July could have been used to take profits on long positions.
Some traders prefer to see the %K line cross the %D line on the right side. This is called a right-hand crossing. In other words, %K is crossing %D after %D has bottomed or topped. When the %K crosses the %D line before the %D has bottomed or topped, it is referred to as left-hand crossing. Of course, this can only be seen in hindsight because, at the time the two lines intersect, you donít know if the %D has reached its ultimate top or bottom.
Left-hand crossings are not as common as right-hand crossings. You can see a left-hand crossing on the S&P chart in early February. The %K dipped below the %D before the %D had reached its ultimate peak.
Stochastics is a very useful technical indicator which helps you with your timing, especially when it is used in conjunction with the other trading tools.
Letís try putting it into practice. Using the slow stochastics indicator pictured at the bottom of this stochastics chart, try to determine the two overbought and oversold areas.
The following chart reveals the overbought and oversold areas:
This is a great example of why stochastics are very useful, but, like any other indicator, not always 100% reliable…
The second ‘oversold’ indication turned out to be accurate – shortly thereafter, both lines crossed back above 20 the Euro took an upward turn and rose about $0.90 (or 9,000 pips).
Likewise, both ‘overbought’ indications proved to be accurate – just after each, the EUR fell about $0.30 and $0.80 (3,000 and 8,000 pips) respectively.
However, the first ‘oversold’ indication turned out to be a relatively false signal. The EUR did not undergo a very significant turn-around. Instead, it continued to go sideways briefly then resumed its downward plunge…
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