Stochastic Day Trading Strategies | Best Ways To Trade Stocks With Stochastic Indicator


The stochastic indicator is one of the most
popular technical analysis indicators used by forex and stock market traders. Once you understand how to correctly use it,
the stochastic indicator can be an invaluable tool to help predict momentum changes. Most traders get confused about how to correctly
read the stochastic oscillator signals under varying market conditions. You see, you need to apply a specific type
of stochastic trading strategy when the market is trending, but you need to read the stochastic
indicator very differently under range bound market conditions. If you misinterpret the market environment,
the same stochastic oscillator value can translate into a very different signal. This is where most forex traders fail. They simply apply the stochastic oscillator
in the same manner, regardless of the underlying market condition, and end up losing money
as a result. So, what is the stochastic oscillator? Stochastic oscillator is a momentum indicator
which compares where the price closed relative to the price range over a given time period. The stochastic is displayed as two lines,
the main line called “%k” and the second line, called “%d,” representing a moving
average of %k. Traders use two types of stochastic oscillators:
fast stochastic and slow stochastic. The fast stochastic oscillator is very volatile,
its reaction to market price will generate many signals. In a strong trending market, the fast stochastic
isn’t able to filter noise and will offer a lot of false signals, which will lead to
bad trades. In order to manage the signal in a more efficient
way, the slow stochastic oscillator was developed. The slow stochastic oscillator helps to smooth
the noise and replaces the %k line with the %d line and replaces the %d line with a 3
day moving average of %d. Slow stochastic oscillator was basically designed
to reduce volatility but in a strong trending market suffers from the same problem as the
fast one, it offers many false signals. Stochastic oscillator comes with the standard
5.3.3 settings. Other common settings are 8.3.3 and even 14.3.3. Now, depending on your trading style, you
have to decide how much noise you’re willing to accept with the stochastic. Low values for the stochastic oscillator will
make the indicator over-sensitive. A stochastic with lower settings will offer
a lot of signals, but also comes with a lot of market noise. Higher values for the stochastic indicator
will make it less sensitive to market noise. This will lead to fewer signals, as the indicator
is smoothed. If you want a higher number of signals when
you trend-trade, then lower settings on the stochastic will suit you. If you are a swing trader or a position trader
and want to eliminate market noise, then higher settings on the stochastic will help you do
that. A lot of traders look for the “perfect settings”
on the stochastic indicator when they trade the forex market or the stock market. The reality is that there isn’t one. You just have to know your trading style. You then have to back test different settings,
depending on the market you are trading and the timeframe you are analyzing. I prefer to use the stochastic oscillator
with 8.3.5, on higher timeframes. Now, how to use stochastic indicator. The most popular method of generating entry
signals (but not the smart one) is to consider the stochastics indicator as an overbought/oversold
indicator. The majority of trading books teach you that
a buy signal occurs when the stochastic moves below 20 level, into oversold area, and then
crosses back above that threshold. And a sell signal occurs when the oscillator
moves above 80 level, into overbought area, and then crosses below that threshold. Here’s the reality: this strategy works
only during non-trending conditions and will fail during strong trending phases. During a non-trending market, the stochastic
generates some pretty good signals. In a trending market however, the stochastic
oscillator generates a lot of false signals. The misconception of overbought and oversold
is one of biggest problems and faults in trading with stochastic. After many years and a lot of money lost I’ve
realized that the stochastic indicator does not show oversold or overbought prices. It shows momentum. When the stochastic is above 80 it means that
the trend is strong and not, that it is overbought and likely to reverse. A high stochastic means that the price is
able to close near the top and it keeps pushing higher. A trend where the stochastic stays above 80
for a long time signals that momentum is high and not that you should get ready to short
the market. You see this concept on every chart. The price enters an overbought area during
a strong trend, and stays overbought for a long period. You don’t want to be in the position of
traders that shorted the market, hoping for a reversal. A smarter entry would be on the long side,
against traders that consider the price to be overbought and incapable of going higher. The second most utilized stochastic oscillator
signal is the crossover signal, which happens when the %k line crosses above the %d line
and generates a buy signal. On the other hand, when the %k line crosses
below the %d line, it generates a sell signal. Once again, these stochastic oscillator crossover
signals are reliable during a range bound market, but these signals tend to become a
lot less reliable when the market is in a strong trend. You can still rely on the stochastic oscillator
crossover signals as a trend continuation signal. For example, if the market is in an uptrend,
you search only for crossover buy signals on the stochastic oscillator. So you’re not interested to short the market,
you simply want to ride the trend by taking buy crossovers. Similarly, if you see a crossover sell signal
during a downtrend, you can also rely on the signal as supporting evidence that the downtrend
is likely to continue, ignoring buy opportunities. Maybe the most elegant approach is to look
for price/oscillator divergences. A divergence occurs when price action differs
from the action of the stochastics indicator. In other words, the market momentum isn’t
reflected in the price, which could be an early indicator of a reversal. A classic divergence occurs when prices form
a lower low while the stochastic forms a higher low (indicating a possible buy), or when prices
form a higher high while the oscillator forms a lower high (indicating a possible sell). When a divergence occurs, a potential change
in price direction could be on the cards. This is my favorite method to trade with stochastics
oscillator. I determine the main trend with a 200-period
exponential moving average, and i only trade classic divergences in the direction of the
main trend. So, i ignore the divergences that occur on
the pullbacks or corrections of the main trend. Basically, when the price is above the 200
EMA, I search for divergences on the lower side of the stochastic, and when is below
the 200 EMA, I look at the upper side of the indicator. Also, I only trade on h1, h4 and d1 timeframes,
in order to reduce market noise and filter the bad signals occurring on shorter time
frames. The stochastic oscillator is an excellent
tool for spotting hidden divergences. If you are a trend trader, hidden divergences
should be one of your most important tools. Hidden divergences signal momentum coming
into the main trend, suggesting a possible continuation in the main direction of the
trend. For some reason, hidden divergences are harder
to spot by many traders, despite the fact that represent a high probability pattern. When trading hidden divergences with the stochastics
oscillator, you have to look for: Higher lows of the price but lower stochastic
values during an uptrend Lower highs of the price and higher stochastic
values during a downtrend Pay attention at this chart. The price action indicated a downward momentum,
with the price making lower highs. However, despite the fact the price was making
lower highs, the stochastic oscillator recorded higher highs, thus forming a hidden divergence. As you can observe, several bearish hidden
divergences occurred during this period, signaling that sellers were in strong positions to enter
the market. The trick is to determine the main trend and
only take positions in the direction of the trend. So, don’t chase all the divergences that
occur on the chart. Go for the ones with a higher probability:
the ones in the direction of the main trend. Another way in which traders use the Stochastic
oscillator is to take signals when the indicator crosses the 50-level. When stochastic indicator crosses above the
50-level, this signals buying pressure When stochastic indicator crosses below 50-level,
this signals selling pressure This method is not used often by traders. I would say that this is an underrated method
of trading with the stochastic indicator. Like i said before, the big problem is that
many traders see the stochastic indicator mainly as an overbought/oversold indicator. Instead of thinking in terms of buying pressure
and selling pressure, their first impulse is to seek for overbought and oversold areas. That’s why a smarter way is to look for
trend strength and continuation movements. A 50-level crossover of the stochastic indicator
could be a solution, but only in combination with another tools. By combining it with other tools, you will
avoid getting beaten by the market because after all, stochastic is a lagging oscillator. As always, if you learned something new, make
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