Let’s have a look at a little thing called Stochastics, and how you can work it into your trading strategy.
What are Stochastics?
To start simply, ‘Stochastics’ (or to give it its full name, ‘Stochastic Oscillator’), is a momentum indicator used to provide insight into potential market direction.
Basically, it allows you to compare the closing price of an underlying with the underlying’s range as defined by support and resistance levels.
It’s based on the theory that during a market uptrend, prices will remain equal to or above the previous closing price, and that in a downtrend, prices will be equal to or below the previous closing price.
How to use it:
You need to plot two lines: the D line and the K line.
The K line provides momentum based on closing price high and low, where you define the number of periods for the high and low.
The D line is usually the 3 period EMA of the K line.
These results are normalized on an index value between 1 and 100. You can see how to plot this in the example below:
Here, the Stochastic indicator has been set up with the yellow K line, with a 21 day range, and the green D line as a 3 period EMA of a 14 period K line.
The next step is to look for a cross between the two lines. If the K line (yellow) is above the D line (green), it’s Bullish, and if K is below D, it’s Bearish.
Just like with RSI, (more on that here) Stochastics also has an overbought and oversold region. Typically, a value below 20 is oversold, and above 80 is overbought.
Combining these oversold/overbought signals with the crossing of the K and D lines makes this indicator very powerful.
See it in action:
In the chart above, the circles indicate potential short entry signals- where the K line crosses below the D line in an overbought region.
The square, on the other hand, shows a potential long entry, where the K line crosses above the D line in an oversold region.
The chart below shows what previously happened with these signals:
How to make Stochastics work for you:
To build this into your trading strategy, you need to use your support and resistance lines to move stops on these trades to recent highs and lows to capture the trends.
One more thing:
You can also apply the divergence technique to Stochastics, like RSI. Divergence can either be applied to the K line to offer warning signals, or to the D line to offer a divergence signal between the underlying and the line itself.
The chart below shows the divergence area between the D line and the actual price.
As you can see, there is no real follow through for what should be a push higher. This is an initial warning sign.
Then, when you see the cross in the Stochastics line, it gives you a good entry point.