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Most Effective Strategies To Trade With Stochastic Indicator (Forex & Stock Trading) - YouTube
Channel: The Secret Mindset
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The stochastic indicator is one of the most
popular technical analysis indicators used
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by forex and stock market traders.
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Once you understand how to correctly use it,
the stochastic indicator can be an invaluable
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tool to help predict momentum changes.
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Most traders get confused about how to correctly
read the stochastic oscillator signals under
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varying market conditions.
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You see, you need to apply a specific type
of stochastic trading strategy when the market
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is trending, but you need to read the stochastic
indicator very differently under range bound
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market conditions.
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If you misinterpret the market environment,
the same stochastic oscillator value can translate
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into a very different signal.
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This is where most forex traders fail.
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They simply apply the stochastic oscillator
in the same manner, regardless of the underlying
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market condition, and end up losing money
as a result.
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So, what is the stochastic oscillator?
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Stochastic oscillator is a momentum indicator
which compares where the price closed relative
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to the price range over a given time period.
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The stochastic is displayed as two lines,
the main line called â%kâ and the second
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line, called â%d,â representing a moving
average of %k.
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Traders use two types of stochastic oscillators:
fast stochastic and slow stochastic.
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The fast stochastic oscillator is very volatile,
its reaction to market price will generate
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many signals.
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In a strong trending market, the fast stochastic
isnât able to filter noise and will offer
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a lot of false signals, which will lead to
bad trades.
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In order to manage the signal in a more efficient
way, the slow stochastic oscillator was developed.
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The slow stochastic oscillator helps to smooth
the noise and replaces the %k line with the
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%d line and replaces the %d line with a 3
day moving average of %d.
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Slow stochastic oscillator was basically designed
to reduce volatility but in a strong trending
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market suffers from the same problem as the
fast one, it offers many false signals.
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Stochastic oscillator comes with the standard
5.3.3 settings.
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Other common settings are 8.3.3 and even 14.3.3.
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Now, depending on your trading style, you
have to decide how much noise youâre willing
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to accept with the stochastic.
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Low values for the stochastic oscillator will
make the indicator over-sensitive.
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A stochastic with lower settings will offer
a lot of signals, but also comes with a lot
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of market noise.
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Higher values for the stochastic indicator
will make it less sensitive to market noise.
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This will lead to fewer signals, as the indicator
is smoothed.
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If you want a higher number of signals when
you trend-trade, then lower settings on the
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stochastic will suit you.
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If you are a swing trader or a position trader
and want to eliminate market noise, then higher
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settings on the stochastic will help you do
that.
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A lot of traders look for the âperfect settingsâ
on the stochastic indicator when they trade
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the forex market or the stock market.
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The reality is that there isnât one.
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You just have to know your trading style.
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You then have to back test different settings,
depending on the market you are trading and
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the timeframe you are analyzing.
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I prefer to use the stochastic oscillator
with 8.3.5, on higher timeframes.
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Now, how to use stochastic indicator.
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The most popular method of generating entry
signals (but not the smart one) is to consider
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the stochastics indicator as an overbought/oversold
indicator.
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The majority of trading books teach you that
a buy signal occurs when the stochastic moves
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below 20 level, into oversold area, and then
crosses back above that threshold.
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And a sell signal occurs when the oscillator
moves above 80 level, into overbought area,
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and then crosses below that threshold.
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Hereâs the reality: this strategy works
only during non-trending conditions and will
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fail during strong trending phases.
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During a non-trending market, the stochastic
generates some pretty good signals.
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In a trending market however, the stochastic
oscillator generates a lot of false signals.
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The misconception of overbought and oversold
is one of biggest problems and faults in trading
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with stochastic.
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After many years and a lot of money lost Iâve
realized that the stochastic indicator does
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not show oversold or overbought prices.
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It shows momentum.
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When the stochastic is above 80 it means that
the trend is strong and not, that it is overbought
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and likely to reverse.
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A high stochastic means that the price is
able to close near the top and it keeps pushing
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higher.
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A trend where the stochastic stays above 80
for a long time signals that momentum is high
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and not that you should get ready to short
the market.
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You see this concept on every chart.
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The price enters an overbought area during
a strong trend, and stays overbought for a
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long period.
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You donât want to be in the position of
traders that shorted the market, hoping for
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a reversal.
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A smarter entry would be on the long side,
against traders that consider the price to
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be overbought and incapable of going higher.
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The second most utilized stochastic oscillator
signal is the crossover signal, which happens
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when the %k line crosses above the %d line
and generates a buy signal.
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On the other hand, when the %k line crosses
below the %d line, it generates a sell signal.
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Once again, these stochastic oscillator crossover
signals are reliable during a range bound
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market, but these signals tend to become a
lot less reliable when the market is in a
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strong trend.
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You can still rely on the stochastic oscillator
crossover signals as a trend continuation
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signal.
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For example, if the market is in an uptrend,
you search only for crossover buy signals
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on the stochastic oscillator.
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So youâre not interested to short the market,
you simply want to ride the trend by taking
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buy crossovers.
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Similarly, if you see a crossover sell signal
during a downtrend, you can also rely on the
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signal as supporting evidence that the downtrend
is likely to continue, ignoring buy opportunities.
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Maybe the most elegant approach is to look
for price/oscillator divergences.
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A divergence occurs when price action differs
from the action of the stochastics indicator.
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In other words, the market momentum isnât
reflected in the price, which could be an
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early indicator of a reversal.
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A classic divergence occurs when prices form
a lower low while the stochastic forms a higher
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low (indicating a possible buy), or when prices
form a higher high while the oscillator forms
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a lower high (indicating a possible sell).
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When a divergence occurs, a potential change
in price direction could be on the cards.
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This is my favorite method to trade with stochastics
oscillator.
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I determine the main trend with a 200-period
exponential moving average, and i only trade
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classic divergences in the direction of the
main trend.
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So, i ignore the divergences that occur on
the pullbacks or corrections of the main trend.
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Basically, when the price is above the 200
EMA, I search for divergences on the lower
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side of the stochastic, and when is below
the 200 EMA, I look at the upper side of the
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indicator.
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Also, I only trade on h1, h4 and d1 timeframes,
in order to reduce market noise and filter
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the bad signals occurring on shorter time
frames.
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The stochastic oscillator is an excellent
tool for spotting hidden divergences.
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If you are a trend trader, hidden divergences
should be one of your most important tools.
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Hidden divergences signal momentum coming
into the main trend, suggesting a possible
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continuation in the main direction of the
trend.
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For some reason, hidden divergences are harder
to spot by many traders, despite the fact
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that represent a high probability pattern.
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When trading hidden divergences with the stochastics
oscillator, you have to look for:
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Higher lows of the price but lower stochastic
values during an uptrend
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Lower highs of the price and higher stochastic
values during a downtrend
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Pay attention at this chart.
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The price action indicated a downward momentum,
with the price making lower highs.
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However, despite the fact the price was making
lower highs, the stochastic oscillator recorded
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higher highs, thus forming a hidden divergence.
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As you can observe, several bearish hidden
divergences occurred during this period, signaling
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that sellers were in strong positions to enter
the market.
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The trick is to determine the main trend and
only take positions in the direction of the
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trend.
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So, donât chase all the divergences that
occur on the chart.
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Go for the ones with a higher probability:
the ones in the direction of the main trend.
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Another way in which traders use the Stochastic
oscillator is to take signals when the indicator
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crosses the 50-level.
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When stochastic indicator crosses above the
50-level, this signals buying pressure
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When stochastic indicator crosses below 50-level,
this signals selling pressure
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This method is not used often by traders.
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I would say that this is an underrated method
of trading with the stochastic indicator.
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Like i said before, the big problem is that
many traders see the stochastic indicator
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mainly as an overbought/oversold indicator.
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Instead of thinking in terms of buying pressure
and selling pressure, their first impulse
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is to seek for overbought and oversold areas.
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Thatâs why a smarter way is to look for
trend strength and continuation movements.
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A 50-level crossover of the stochastic indicator
could be a solution, but only in combination
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with another tools.
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By combining it with other tools, you will
avoid getting beaten by the market because
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after all, stochastic is a lagging oscillator.
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As always, if you learned something new, make
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Until next time
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