Today we are going to explore how to effectively use the Stochastic technical indicator to time your trading entries with pinpoint precision.
We are going to discuss ways in which we can use this indicator to ensure we are “buying low” and “selling high” with minimal risk and maximum reward when trading in markets all around the world!
How do we do that?
Let’s find out!
Before we explore the intricacies of the stochastic indicator, we must first build a framework of understanding for the context in which it is used.
The stochastic indicator can be used in trading markets in all conditions however, from my own personal use, I have found it to be most effective and reliable when the market that I am trading is exhibiting trending conditions.
A trend is defined as a series of higher highs and higher lows on a price chart (uptrend), or lower highs and lower lows (downtrend).
Within any trend, we can identify a series of waves.
A wave is simply the movement between each of the lower lows (uptrend) or lower highs (downtrend).
Here’s the part we’re most interested in.
Within each wave of movement, we can identify two cycles – a cycle up and a cycle down. The cycle up is the move from one low to the next high, the following cycle down is the move from that same high to the next low.
Take a moment to study figure1 below to ensure you are confident when it comes to identifying trends, waves and cycles on a price chart.
Figure 1: Trend, Wave, Cycle
Now that we know all about trends, waves and cycles, we can develop an understanding of how the stochastic works within this context.
The stochastic indicator assists us in identifying where cycles begin and end.
When trading, we want to buy at the beginning of a cycle up and sell at the beginning of a cycle down. Sometimes it is very obvious to us when these cycles are beginning and ending, however, we are able to predict these movements with far greater accuracy with the aid of a stochastic.
The stochastic technical indicator was developed by the technical analyst George Lane in the 1950s for the purpose of gauging the momentum of price. As the famous quote from the founder goes, “stochastics measure the momentum of price. If you visualize a rocket going up in the air – before it can turn down, it must slow down. Momentum always changes direction before price”.
This means that once we have an understanding of how to interpret the signals given by the stochastic, we are able to identify when momentum may be slowing down and reversing which is a massive advantage in the highly competitive world of intra-day trading.
Now just before we discuss what signals to buy and sell look like on the stochastic, we must first explain what it actually is and how to set it up.
Figure 2: Stochastic default appearance
The blue line, also known as the “fast line” is the %K line.
The orange line, known as the “slow line” is the %D line (which is a moving average of the %K line)
These two lines oscillate between a range from 0-100.
Also on the stochastic, we have a highlighted area between the values of 20 and 80.
Traditionally, the territory below 20 is considered oversold, and above 80 considered overbought.
We can quickly identify which direction price momentum was traveling at any point in time by examining whether the lines were pointing higher or lower on the oscillator range at the corresponding point on the stochastic.
The settings that you configure your stochastic with determines how reactive to change it will become.
Faster settings are great for use on lower time frames whereas higher settings are generally better suited to swing traders who do concern themselves with the intra-day momentum fluctuations.
The default TradingView settings for the stochastic are %K 14, %D 3, Smoothing 3; which are very effective settings for traders who trade on a 1 hour to daily time frame charts.
For traders who prefer to trade on lower time frames such as the 1-minute of 5-minute charts, I recommend %K 5, %D 3, Smoothing 3.
You may experiment with different settings for your own stochastic to see how it affects its visual appearance on your own charting platform.
Higher input values will display visually far smoother and give less frequent signals.
Lower input values will make the stochastic far more reactive and likely to display many false signals which are referred to as “noise”.
Whatever you choose, the more experience you gain with the stochastic indicator and the particular settings you decide on, the better you will become at recognizing reliable signals and being able to quickly differentiate them from the surrounding noise.
This brings me to the next concept that we must learn about – how to recognise buy & sell signals from the stochastic.
Figure 3: Stochastic “buy” signal
A signal to “buy” is given when both the lines of the stochastic are in oversold territory (below 20) and the fast line crosses above the slow line and aims higher. This indicates a shift of momentum may be occurring and price is likely to move higher.
The opposite is true for a “sell” signal. To sell, we must see both lines of the stochastic in overbought territory (above 80), and the fast line must cross below the slow line and aim lower.
As a general rule, we always want to be trading with the trend, never against it. This will ensure our trades have a higher likelihood of resulting in our favor. To do this, we generally only want to take entry signals to buy when price is trending higher, or to sell – when price is trending lower. Trading against the trend is equivalent to swimming against a tide. We will have a far easier time if we work with the trend instead.
If the trend is not obvious you may use another technical indicator such as a 200EMA / 200SMA to determine the current trend of price.
We must also be sure to never trade only based on a stochastic signal. We must first gather additional information to support the stochastic’s signals to further increase our probabilities of success. This may include some or all of the following:
- Additional technical indicators (Bollinger Bands / RSI / EMA / MACD / etc.)
- Price action indicative of a reversal (hammer candle / doji / engulfing pattern / etc.)
- Key price level inflection points (support or resistance areas)
- Level 2 confirmation (order book momentum shift / change of character on the tape)
The greater the level of confluence between all of these variables, the greater the chance of success for the trade.
You must decide for yourself which supporting information you will look for when trading based on the stochastic.
I highly recommend back-testing your variable choices for yourself or trading them in a simulated account to have an understanding of what results you may expect before trading them live.
Another advantage of using the stochastic is that it offers us an obvious and logical location to place our stop-loss.
Our stop loss is to go directly below the lowest point of the cycle down (when buying to enter our position) or the highest point of the cycle up (when selling to enter our trade).
This ensures that if the signal that we have made our trading decision on turns out to in fact be invalid and only noise, we stop out quickly and for only a small loss.
As we have discussed, the stochastic is an excellent technical analysis indicator to add to your trading arsenal.
With practice and experience, you will be able to use the stochastic for yourself to master trading entries and exits whilst keeping your losing trades at a fraction of the size of your winners.
If you would like further information or examples, check out our video at the following link:
Head over to www.tradingview.com to try the stochastic indicator for yourself and experiment with how the different settings react across different time frames to find out what settings best suit your own style of trading!