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.

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.

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.

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.

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.

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

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.

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.

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.

If 14,3,3 is a great setting, why not 13?

What about 5,3,3?

What about any combination you can think of?

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.

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.

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.

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.

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.

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.

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.

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.

This chart shows a market in both conditions and you can see that:

Overbought - Market keeps going higher

Oversold - Market keeps going lower

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.

When testing anything in trading, ensure you are seeing the whole

picture and not just what you want to see.

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.

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

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.

You may find opportunities when a confluence of technical factors line up

when the market is oversold or overbought.

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.

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.

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

executing them.

DIVERGENCE TRADING Price goes one way and the Stochastic goes another, divergence is usually the

play traders look for.

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.

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.

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

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.

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.

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.

This chart shows the action after divergence showed up from the

previous chart.

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.

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.

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.

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.

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.

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.

You can see the nice separation between the two slow Stochastic lines

and indicates "orderly" price movement.

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.

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.

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.

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.

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.

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

decision.

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.

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?

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.

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

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:

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

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

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

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.

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.

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.

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.

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.

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.

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.

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.

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.

As pointed out, to do so will not equate to a positive trading outcome.

You need more.

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.

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.

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.

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.

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.