A Powerful Momentum Oscillator
The stochastics indicator is a momentum oscillator which measures the strength of price moves, similar to the RSI indicator. However, the stochastics also has a structural reference which basically means the indicator is looking at the most recent close compared to the high and low over a certain period. So, the indicator essentially measures momentum in the market and signals momentum as being either overbought or oversold.
The indicator is setup in the same way as the RSI with a lower and upper limit but you’ll notice with the stochastics that the upper limit indicating overbought is at 80 and the lower limit indicating oversold is at 20. The default lookback settings on most platforms are 5,3,3. You can adjust the settings manually but please note that the lower the numbers, the more sensitive the indicator will be to price and the higher the numbers the less sensitive the indicator will be to price.
You might also notice that the indicator actually has two lines so we have the D line and the K line. The K line is the slower line and the D line is the faster line and essentially when the D line crossed above the K line it is classed as bullish and vice versa when the D line crosses above the K line it is classed as bearish. But we will look at this in context shortly.
As with most momentum indicators when it comes to trading them, the methods we can use fall into two broad categories, the first is using the indicator to fade price action and the second is using the indicator to highlight divergence. So, let’s look at some examples and discuss these methods.
Overstretched Momentum Reversals
In this example you can see several highlighted areas where price made a reversal. The important thing to notice is what is happening with the stochastics indicator in these areas. You can see that at the point that price reverses lower and sells off, the indicator is typically up at the upper threshold, suggesting that bullish momentum is overstretched and a bearish reversal is likely. Also, notice that at the points where price reverses higher, the indicator tends to be down at the lower threshold suggesting that bearish momentum is overstretched and a reversal higher is likely. Just this image alone should highlight how effective the stochastics indicator can be for catching reversals.
Waiting For The Indicator To Confirm Entry
In terms of how we want to trade these reversals, the key thing is that we don’t just put on a trade as soon as the indicator line hits a threshold level. So, where the indicator line hits the overbought level, we don’t just set a short trade immediately, we want to wait for the indicator line to cross back below the overbought threshold which signals that the reversal is beginning. Similarly, where the indicator line hits the oversold level, again, we don’t just set a long trade immediately, we need to wait for the indicator line to cross back above the oversold threshold which signals the reversal is underway.
Now, the reason that we do this is because, as highlighted, we need to wait for the indicator to signal that the reversal is underway. The indicator line simply hitting one of the threshold doesn’t mean that a reversal has started and price can often continue pushing which can lead to unnecessary losing trades.
In this example, you can see where price is trading higher while the indicator is moving up towards the overbought level meaning that we should be on look out for a reversal opportunity. At the first point, you can see where the indicator hit the overbought level, now if we had immediately sold there, you can see that we could have ended up in a losing trade because price continued to move higher. However, at the second point you can see where the indicator line actually crossed back below the overbought threshold signalling that the reversal was underway and you can see how price actually started selling off at that point. This is a great example of how to use the indicator to highlight a reversal opportunity and also properly time your entry.
Now, this isn’t to say that trading in this manner will help you avoid all losing trades because there are no 100% systems, but, trading in this manner is definitely a smarter and more strategic way and will help you protect against some losses and find better entry points to the market which is what we always want to be doing no matter which strategy or indicator we use.
Another fantastic way to use the stochastics indicator is to use it to highlight divergence. This term basically refers to a situation where the indicator doesn’t support the moves that price is making. So, basically price is telling us one thing, such as price is rising, but the indicator is telling us the opposite, suggesting that price is likely to reverse lower and vice versa.
In this image we have a textbook example of bearish divergence. You can see that price is travelling higher in a classic bull trend structure putting in higher highs and higher lows. However, notice what is happening with the indicator as price is moving in this way, the indicator is actually putting in lower highs. So, what is this telling us? Well think about it, if this bullish move in price was really strong and likely to continue then on each upswing there would be the same amount of momentum or more momentum in the market meaning that the indicator would be putting in higher highs. However, because the indicator is putting in lower highs, this suggests to us that on each new upswing the trend is actually losing strength and so is vulnerable to a reversal lower. So as soon as we start to see this divergence we know that a reversal is likely and we can look for a trading opportunity.
Hopeflly you can see just how simple yet powerful the stochastics indicator can be. The beauty of the indicator is that it works on all timeframes and is fantastic when combined with other indicators or used in a stand alone way with simple price action. If you’re interested in learning more abou this indcator, make sure to join our Day Trading Indicators webinar next week.