While basic chart analysis will tell you the trend, the stochastic offers something more when used as a filter, it helps you time your trades with better accuracy and greater profits.
Its real value is that at significant chart points where you are looking for a top or bottom, it will help you enter or exit your trades for greater long term profits.
For long term trader’s day traders or swing traders it’s the ultimate timing filter, in currencies or any ther market.
An Introduction
George Lane, who developed the indicator, postulated that in an upwardly-trending market, prices tend to close near their high, and in a downwardly-trending market, prices tend to close near their low.
As an upward trend takes its course, prices tend to close further away from the high, and as a downward trend develops, price tends to close away from the low.
As a timing indicator
The theory of the stochastic is based upon these are the catalyists which indicate the beginning of a trend reversal.
The stochastic indicator defined:
1. Is a momentum oscillator that can warn of strength or weakness in the market, often well ahead of turning points.
2. Is based upon the assumption that when a financial instrument is rising it tends to closer to the high than when it is falling, where it tends to close near its lows.
How the indicator is plotted
The stochastic is plotted as two lines %K, a fast line and %D, a slow line.
The %K line is more sensitive than %D
The %D line is a moving average of %K.
The %D line triggers the trading signals.
Although this sounds very complicated, it is actually very similar to the way a moving average is plotted.
Think of %K as a fast moving average and %D as a slow moving average.
Don’t worry
You don’t need to know how an internal combustion engine works to drive a car and stochastics are the same.
Their plotted on most major chart services, take a look at futuresource.com as an example and there are many others.
All you need to do is look at the set up, all the maths is done for you
The lines are plotted on a 1 to 100-scale. "Trigger" lines are normally drawn on stochastics charts at the 80% and 20% levels.
A signal is generated when the lines cross. The zones above and below these two lines are referred to as stochastic bands.
Overbought and oversold levels
The 80% value is used as an overbought signal, and the 20% is used as an oversold signal.
The Stochastic Oscillator generates signals in three main ways:
1.Extreme values
When the 20% and 80% trigger lines are crossed.
Buy when the stochastic falls below 20% and then rises above that level.
Sell when the stochastic rises above 80% and then falls below that level.
The pattern of the stochastic is also important; when it stays below 40-50% for a period and then swings above, the market is then shifting from an overbought scenario and giving a buy signal and vice versa when it stays above 50-60% level for a period of time.
Stochastic Crossovers
Crossovers are very effective and work as follows.
Buy when the %K line rises above the %D line and sell when the %K line falls below the %D line. Beware of short-term crossovers that may generate false signals.
The preferred crossover is when the %K line intersects after the peak of the %D line ( known as aright-hand crossover).
Beware though, crossovers often provide choppy signals that need to be filtered with the use of other indicators.
Stochastic Divergences
Divergences between the stochastic and the underlying price trend also offer good signals to trade off.
For example, if prices are making a series of new highs and the stochastic is moving lower, you may have a warning sign of weakness in the market.
Caution
As with any technical indicator its does not work by itself, so make sure you have signals from the charts before adding the stochastic as a filter.
The ultimate trading filter
Used as a filter, it can warn of strength and weakness and get you into or out of the market, to maximize profits, or just as importantly help you minimize losses.
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