Trading using Stochastic

Last Week we discussed  Technical Indicator – Stochastics An Introduction Lets discuss today how to Trade using Stochastic

 

The Stochastic Oscillator can be used to generate Buy and Sell Signals as follows

1. Extreme Values (Overbought Oversold)

2. Stochastic Crossovers

3. Stochastic Divergences

Extreme Values (Overbought Oversold)

The stochastic oscillator is plotted within a range of 0 and 100 and signals overbought conditions above 80 i.e. Index/stock is trading near its upper trading range and oversold conditions below 20 i.e. Index/security is trading near its lower trading range.

Buy when Stochastic move above 20 line.

 Sell when Stochastic move below 80 line.

As shown in below EUR/USD 15 mins chart

It is important to note that overbought readings are not necessarily bearish. Securities can become overbought and remain overbought during a strong uptrend. In the same fashion oversold readings are not necessarily bullish. Securities can also become oversold and remain oversold during a strong downtrend.

 

Let’s illustrate the above concept with an Apple charts from 20Sep2010 Apple gave breakout and after that stock was taking support at its rising trend line and was in its bull run.

In trending market we should ignore Stochastic Overbought conditions and Oversold Conditions.

STOCHASTIC CROSSOVERS

We can use stochastic crossover to generate buy and Sell Signals as follows

Buy when Stochastic moves up from below 20and the %K line (Blue Line) rises above the %D line (red line)

Sell when Stochastic moves down from above 80 and when the %K line (Blue line) falls below the %D line (%K Li

 

As Seen from below IBM chart Buy signal got triggered @$123.29 and Sell got generated @$130.8

 

 

Beware though, crossovers often provide choppy signals that need to be filtered with the use of other indicators

 

STOCHASTIC DIVERGENCES

Divergence occurs when the direction of the price trend and the direction of the indicator trend are moving in the opposite direction. This signals that the direction of the price trend may be weakening as the underlying momentum is changing.

There are two types of divergence –

• Positive or Bullish Divergence –Positive divergence occurs when the indicator is trending upward while the security is trending downward.
• Negative or Bearish Divergence — Negative divergence gives a bearish signal as the underlying momentum is weakening during an uptrend.

 

Divergences should be never taken as it is and trader should wait for confirmation to signal actual reversal.

Positive Divergence is confirmed with break of resistance on price chart and Stochastic above 50.

Bearish Divergence is confirmed with break of support on price chart and Stochastic below 50.

Let’s illustrate the Divergence with the Nifty Daily(Indian Stock Market) chart as below

As seen from above Daily Chart of Nifty, It was making higher highs as indicated in chart but Stochastic is making lower low. After market peaking out around 6324 Nifty started correcting but reversal is confirmed on breaking of crucial support. Once the support got broken Nifty gave a Bear hug correcting 8%.

 

This is how power of Divergences can be used by trader to get maximum profit out of his trades.

 

Conclusion

This leading indicator will create many buy and sell signals that make it better for choppy non-trending (Sideways) markets instead of trending markets where it is better to have less entry and exit points.

It is important to use the Stochastic Oscillator with other technical analysis tools like RSI, Bollinger band Volume, support/resistance.