Stochastics Indicator

Alright…the stochastics has to be one of my most favorite, many a pips have I made using this tool alone !

The stochastic indicator was developed by Dr George Lane and is considered as one of the most popular and powerful indicators in the trading world. It is a momentum indicator that simply indicates overbought and oversold levels, where overbought region is near the 80 level and the oversold region is near the 20 level (more on this below).

This indicator ranges between 0-100 and consists of two lines namely the %K (main line) and %D (signal line). When those lines are in the upper region near the 80 level, it is referred to as an overbought market meaning that most probably there will be a reversal in price. On the other hand, when the lines are at the lower region near the 20 level, it means that the market is in an oversold market where price will most likely reverse in the opposite direction.

So, what are the different ways to using this indicator?

1. Looking for Divergence
2. Enter a trade when the lines crossover
3. When the lines break the 20 and 80 levels respectively.

Use this indicator to spot the divergence between the %D and price. When %D makes lower lows while prices make higher highs, the market is considered overbought and when %D makes higher highs and prices make lower lows, market is referred to as oversold.

Enter a trade when the lines crossover:

When %K (main line) crosses %D (signal line) line from above this gives you an idea that the market is turning bearish and you should think of selling. In the instance that crossover occurs from the bottom, this means that most probably the market is turning bullish and that buying should be in your agenda.

Lines breaking the 20 and 80 levels:

When the price has bottomed and line has started to move north, take the trade for a buying position when both the %K and %D break the 20 level. When the price has topped and lines are heading down, take the trade a sell when both lines breaks the 80 level.

Note: this chart tool seems really easy to use at start but don’t be fooled, a lot of practice is needed to master this great tool.

Here is a 1-hour chart with a stochastic oscillator attached:

In real trading situations you have to be very careful how you analyse this indicator. As you may see from the screenshot above, this indicator will give a few false signals even if price is in the overbought region.

Only with experience can you recognise these misleading signals so do not attempt to rely soley on just this indicator or you can kiss your pips goodbye in a very short time.
The big disadvantage in using a leading indicator such as the stochastic oscillator is that it attempts to predict price behavior well before it happens.

For example you may get a confirmation trade from the stochastic and decide to jump in the market. As soon as you take the trade, price reverses and shoots in the opposite direction leaving you and your margin to suffer.

My personal experience with the stochastic is that it is best used in conjunction with another lagging indicator like the MACD or the Moving Averages.

You may read more about leading and lagging indicators on the trader’s corner to have a better idea of how they differ from each other.

Below is a 4-hour with a 50 SMA acting as a lagging indicator:

Using the stochastic oscillator with a lagging indicator that can define the trend of the market will help you pick the correct signals from the bad ones. Using those two indicators as a team is definitely not 100% accurate and if it were, I would probably be on an island in the Bahamas. However, it does the job to about 70% accuracy.

Note: I personally use the 50 SMA in most on my trading system; it provides me with good intermediate trend analysis.

Happy Trading,

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