http://www.netpicks.com/tjlivewebinar - See Our Trading Systems In Action As with any trading indicator, the Stochastic Oscillator is only a tool and should be used as part of an overall trading strategy. I’m not going to draw a conclusion for you as to the effectiveness but will cover different uses for the Stochastic. I also am only going to cover the slow Stochastic because I’ve always found the slow version much easier on the eyes then the fast Stochastic as you can see from this graphic. WHAT IS THE STOCHASTIC OSCILLATOR You’ve heard of momentum in trading and the Stochastic is designed to give you an objective measure of the momentum in your trading instrument. It’s bounded by the numbers 0 and 100 and will oscillate between those two areas. http://www.netpicks.com/slow-stochastic-oscillator/ - Read more

2. As with any trading indicator, the
Stochastic Oscillator is only a tool and
should be used as part of an overall
trading strategy.
I'm not going to draw a conclusion for
you as to the effectiveness but will
cover different uses for the Stochastic.

3. I also am only going to cover the slow Stochastic
because I've always found the slow version
much easier on the eyes then the fast Stochastic
as you can see from this graphic.

4. You've heard of momentum in trading
and the Stochastic is designed to give
you an objective measure of the
momentum in your trading
instrument. It's bounded by the
numbers 0 and 100 and will oscillate
between those two areas.

5. One area you want to be clear on is
that simply because the lines on the
"Stochs" moves up and down, it does
not always track price movement.
Remember, it measures momentum in
that it tells you via the direction if
price is closing closer to the highs or
lows over a set period of time.

6. Some will say that it is an
oversold/overbought indicator
however that was not the original
intention of the indicator. George
Lane, the developer of the indicator,
actually used it for stochastic
divergence - the divergence of the
Stochastic when compared to price.

7. There is a big issue even when using
the Stochastic as intended but for now,
just keep in mind that we are looking
at momentum in the market when
using this indicator.

8. You may find different calculations
depending on the charting package
that you are using however this is the
proper formula for the fast Stochastic.
%K=(C-L)/(H-L) x100
C=Close is current closing price L=Lowest low
over X periods. H=Highest high over X periods

9. The slow Stochastic is calculated
differently where %K is a 3-period
moving average of the fast %K. %D is
an x-period moving average of the fast
%K.
Keep things simple. Even if your
charting platform has a different
calculation, just use what is available.

10. Remember that any trading indicator is
simply one cog in the wheel of a
complete trading system. You will
probably not rely on one thing to
indicate a trading opportunity.

11. Many trading indicators will give you
the opportunity to adjust many of the
inputs that will be used in the
calculation. This can be a good thing
when trying to optimize for current
market conditions but it can produce
more headaches than trading results.

12. If 14,3,3 is a great setting, why not 13?
What about 5,3,3?
What about any combination
you can think of?

13. Keep in mind that the shorter the look
back period, the more movement you
will get with the indicator. A setting of
14 will be slower than a 5. Whatever
you determine works for you, just be
consistent.

14. Actually, one of the reasons I prefer
the slow Stochastic is I find it plots
smoother on the charts. The fast
Stochastic is ragged in appearance
which has to do with it being more
sensitive than the slow.

15. There is no best Stochastic setting that
will produce more wins than losses.
When designing your trading system
and trade plans, simply choose the
setting that suits your needs.

16. I have always used the Dinapoli setting
of 8,3,3 and have never changed it. It's
not that I found that the setting was
better or worse than any other, it's just
what I started with and saw no
compelling reason to change the
setting.

17. Now that we know that the Stochastic
is a momentum oscillator that
measures the momentum of the last X
periods (look back), let's look at some
uses of the indicator.

18. There are dangers when trading the
often touted methods without taking a
more critical look at what not only
what the indicator is telling you, but
what price action and structure is
telling you.

19. OVERSOLD AND OVERBOUGHT
This is something you read about quite
a lot and often times it misses the
truth about these levels. These are not
areas you simply want to execute a
counter trade position.

20. We are looking at momentum and
when slow stochastic oversold
overbought momentum is high
enough to force the Stochastic lines
into either of these levels, it indicates
strength/weakness and does not signal
an immediate change in the market.

21. This chart shows a market in both
conditions and you can see that:
Overbought - Market keeps going higher
Oversold - Market keeps going lower

23. Is taking a trade simply because of the
signal of the Stochastic a good idea?
Not in this case although I could
probably find examples of the perfect
reversal.

24. When testing anything in trading,
ensure you are seeing the whole
picture and not just what you want to
see.

25. When you see this condition, think of
it telling you that at this point, the
market is probably in a strong
directional trend and barring any
strong support or resistance, it will
probably continue in that direction.

26. Why probably?
An object in motion stays in motion
with the same speed and in the same
direction unless acted upon by an
unbalanced force - Newton

27. You will get counter moves
(unbalanced force) that may slow
down the momentum of the market
but to reverse it, that force must be
strong. That strength is often found at
historical structure points.

28. You may find opportunities when a
confluence of technical factors line up
when the market is oversold or
overbought.

29. This may be an opportunity to pull some
profits out of the market but you want to
watch how price reacts around these
areas. It must show some sign of weakness
in order for you to find yourself in a higher
probability trade.

30. There are plenty of opportunities for
trades while the market in both states
in this example. I can see range failure
tests, range breaks, and flags broken
with strength and this is only using this
time frame.

31. The key is using your trade plan to
dictate your trading setups, finding
them in favorable conditions, and
executing them.

32. DIVERGENCE TRADING
Price goes one way and the Stochastic
goes another, divergence is usually the
play traders look for.

33. This was the original play that Lane
was looking at when developing the
Stochastic but like I keep saying, an
indicator signal by itself is not always
the smartest opportunity.

34. Remember that the Stochastic is bounded
in between a 0 and 100 level. It can't go
lower or higher than those so keep that in
mind when looking at divergence.

35. If price is in downtrend, compare lows
of price and Stochastic.
If price is in uptrend, compare highs of
price and Stochastic.

36. If price makes lower low but Stochastic
makes higher low, consider longs.
If price makes a higher higher but
Stochastic makes lower high, consider
shorts.

38. This is down trending price and you
can see that price puts in a low lower
than the previous low. The Stochastic
puts in a higher low which indicates
the potential for a move up in price.

39. Remember that the Stochastic
measures momentum and even
though price is moving down, the
momentum calculation is pointing to
the upside. It does not mean we are
about to have a strong trend to the
upside.

40. This chart shows the action after
divergence showed up from the
previous chart.

42. Price action was not the most
conducive to stress free trading and
just looking at the candlesticks, you
can see upper/lower shadows and
small range candles.

43. That said though, the right side of the
chart is a nice stair stepping uptrend
pattern that could have resulted in
some trading profits depending on
your trading style.

44. You may be seeing a pattern in these
two examples. It really does not
matter what an indicator is telling you
if price is not following suit. Indicators
like the Stochastic are an "in addition
to" component of a trade plan that
takes into account true market action
and structures of price.

45. QUALITY OF PRICE TREND
One component of a Stochastic
oscillator trading strategy you may
want to employ is an objective
measure of the quality of the price
trend.

46. If price is trending to the downside,
your trading plan may call for
continued short positions instead of
counter trend trades. All trends are
not created equally and the Stochastic
will help you determine the quality of
the momentum of the trend.

48. The previous chart shows a Stochastic
line cross while in the oversold area.
This indicates momentum has turned
bullish and we are in an overall
uptrend in price.

49. You can see the nice separation
between the two slow Stochastic lines
and indicates "orderly" price
movement.

50. Compare that to the area to the right
of the highlighted zone. The lines are
compressed together and price is
plotting weak directional candles as
well as strong directional candles all
while travelling in a sideways range.

51. Look for a separation between the
lines as well as sweeping up or down
moves of the Stochastic to indicate a
trend quality that you may find
conducive to better trading
opportunities.

52. One important point to highlight once
again is that the Stochastic is a bound
indicator. It is very likely that you can
be in an overbought/oversold state
with the lines tight together but still
have decent price action for trading.

53. The lines can't push higher than 100 or
lower than 0 so ensure you also take
into consideration the state of the
price action.

54. STOCHASTIC CROSSES + DIVERGENCE + PRICE
We can take some of what we have
covered and add a few layers of
confluence to it that may add to the
probability of some price movement in
our favor.

55. To do so, we are going to add in some
price structure to aid us in a trading
decision.

56. Trading an indicator signal blindly is a
recipe for disaster but adding in a what
the chart itself has to offer is a totally
different ballgame.
This is why Netpicks always incorporates
10-20% non-mechanical variables into
each and every trading system and plan.

57. One thing that we haven't covered is
when the lines on the Stochastic cross.
We will cover it in the chart example
but if crossing to the upside from
oversold areas, that is considered a
bullish move. Why?

58. Stochastic measures momentum and
the cross signifies that after the move
down in price for example, we are
getting momentum starting to the
upside when the cross occurs.

59. Do you trade that whenever it occurs?
Of course not.

61. In the chart, price has moved down,
put in a bottom and then rallied. Price
came back down and that is where we
pick it up from:

62. 1. Double bottom. Price puts in a
reversal candle. We are in oversold
territory with bullish divergence.
Stochastic line cross.

63. 2. Counter trade off of previous
resistance. Stochastic line cross in
overbought zone. No real candlestick
reversal pattern.

64. 3. Pullback to support and up sloping
trend line. Stochastic line cross in
oversold zone. Strong break of doji
type candlestick.

65. This was making a case for trading as
opposed to just firing off a trade
because the trading indicator gave a
typical (and textbook) signal.

66. When you add in a confluence of
factors including price structures, you
improve your odds of some move in
your favor. Nothing is perfect so having
a trade plan that includes risk
tolerance and trade management is
extremely vital.

67. TRADE THE MOMENTUM TREND
A slow Stochastic trend is the
momentum trend and for this you may
want to consider using a MTF (multiple
time frame) approach in your trade
plan.

68. Essentially we are looking for the
momentum direction on a higher time
frame and looking for trades on lower
time frames in the same direction.

69. When using a multiple time frame trading
approach, look for a difference of 3-5
times. For example, you can use a 60
minute trend for trades on the 15 minute
time frame. For simplicity, traders may look
at the daily chart for the momentum trend
while in Forex, some traders use the daily-4
hour combo and the 4 hour-1 hour combo.

71. Here we have the daily Stochastic on
the bottom with 60 minute data on
the price chart.
You can see when the daily Stochastic
trend was up, there were multiple
opportunities for trading ranging from
flags to failure tests of ranges.

72. The right side shows a daily Stochastic
trend to the downside with a cross to
the upside midway between OS/OB.
The trick is to note the slope of the
thicker line and not to be seduced into
finding long positions.

73. To do so would have you in a losing
trade quickly. There are a number of
trading opportunities simply using
structure levels formed as price stair
steps downwards.

74. INDICATORS JUST PART OF THE
TRADING PUZZLE
There are still many people who
believe you can simply apply an
indicator to a trading chart and take
the signals when presented.

75. As pointed out, to do so will not
equate to a positive trading outcome.
You need more.

76. Simply applying the basics such as
support and resistance or trend lines
will at least give you something to
trade against. They can also keep you
out of taking trades directly into points
of the chart that may offer some
opposing forces that will challenge
your trades.

77. You want to ensure that any trading
system you use that has indicators is
also thoroughly tested and if based on
multiple indicators, that they
compliment each other. Having two
momentum indicators for example is
not needed and just adds a layer of
complexity to any trading strategy.

78. Remember one of the key elements of
a trading plan is how you manage your
trades and the risk you will take.
Those are as crucial, if not more so,
than what setups you use for your
trades.

79. Whether you use the slow Stochastic
as part of your trading plan or any
other indicator, ensure that you
critically analyze the information it
presents so you can see both the pros
and cons of each. Testing a trading
system and each variable is hard and
tedious work.

80. If you think you are not going to
approach it in a diligent manner or
want to get ideas on how to design
your own, join us for a free webinar
where you can see one of most
popular trading systems to date in
action. You can register for the trading
webinar here.