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A lesson on how to trade the stochastic oscillator for active day traders and investors using technical analysis in the stock market, forex market. and futures market.
In our last lesson we learned about the RSI indicator and some of the different ways traders of the stock, futures, and forex markets use this in their trading. In today's lesson we are going to look at another momentum oscillator which is similar to the RSI and is called the Stochastic.
Let me start by saying that there are 3 different types of stochastic oscillators: the fast, slow, and full stochastic. All of them operate in a similar manner however when most traders refer to trading using the stochastic indicator they are referring to the slow stochastic which is going to be the focus of this lesson.
The basic premise of the stochastic is that prices tend to close in the upper end of their trading range when the financial instrument you are analyzing is in an uptrend and in the lower end of their trading range when the financial instrument that you are analyzing is in a downtrend. When prices close in the upper end of their range in an uptrend this is a sign that the momentum of the trend is strong and vice versa for a downtrend.
The Stochastic Oscillator contains two lines which are plotted below the price chart and are known as the %K and %D lines. Like the RSI, the Stochastic is a banded oscillator so the %K and %D lines fluctuate between zero and 100, and has lines plotted at 20 and 80 which represent the high and low ends of the range.
Whatever charting package you use will calculate the lines for you automatically but you should know that the data points which form the %K line are basically a representation of where the market has closed for each period in relation to the trading range for the 14 periods used in the indicator. In simple terms it is a measure of momentum in the market.
The %D line is very simply a 5 period simple moving average of the %K line. Lastly you should know that you can change the inputs for the indicator and use for example a 3 period moving average of the %K line to get faster signals, however as this is an introduction to the indicator and because most traders I know do not change the standard inputs, I do not recommend changing them at this point.
Like the RSI the first way that traders use the stochastic oscillator is to identify overbought and oversold levels in the market. When the lines that make up the indicator are above 80 this represents a market that is potentially overbought and when they are below 20 this represents a market that is potentially oversold. The developer of the indicator George Lane recommended waiting for the %K line to trade back below or above the 80 or 20 line as this gives a better signal that the momentum in the market is reversing.
The second way that traders use this indicator to generate signals is by watching for a crossover of the %K line and the %D line. When the faster %K line crosses the slower %D line this is a sign that the market may be heading up and when the %K line crosses below the %D line this is a sign that the market may be heading down. As with the RSI however this strategy results in many false signals so most traders will use this strategy only in conjunction with others for confirmation.
The third way that traders will use this indicator is to watch for divergences where the Stochastic trends in the opposite direction of price. As with the RSI this is an indication that the momentum in the market is waning and a reversal may be in the making. For further confirmation many traders will wait for the cross below the 80 or above the 20 line before entering a trade on divergence.
As the RSI and Stochastic are similar in nature many traders will use them in conjunction with one another to confirm signals.
That's our lesson for today. You should now have a good understanding of the Stochastic Oscillator and some of the different ways that traders use this in their trading. In tomorrow's lesson we are going to look at an indicator which allows us to gauge the volatility of a financial instrument over a given time called Bollinger Bands.
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At stochastic if traders can identify the points at which a trend runs out of steam, then they can potentially benefit from not only the existing trend but from any countertrend price action as well. The stochastic indicator plots two interactive lines as and an additional moving average known as %d line. The moving average tracks the changes or deviations in what is called the % k line. My broker AAFX gives me regular webinars and trading education lessons.
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That divergence information is valuable to have, it's the only tool i use next to price action trading. It's something you can't always easily find in price action. The overbought, oversold levels don't mean much in Forex so i never bother with it.
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The price can do what it likes, price action alone doesn't work. Try flying a plane with no indicators. You will probably crash. With indicators you probably won't.
It's what works for individuals... being a trader you'd know that.
+Lost in Japan Price action is great to get a sense of what is the next move. However, I have seen one HF manager just trade from a multiple SMA and another just trading with 9 indicator. There are many ways to skin a cat. All depends on the individual.
+Tony Cao dont believe his bs, look at his video's even him use indicator even its a MACD , one thing you should know , everyone has their own style of trading , doesnt necesary mean your a pros doesnt use stoch , i know pros that making millions a month use stoch.
what a waste of time using indicators that are secondary. majority of trades executed in the market are from computer trading software that don't use indicators. most of them use price action and volume with complicated formulas. Algos don't use indicators, why should we ?
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I like using stochastics for reversals. Together with the Pipdaq setups they work great as I get trend continuation trades and counter trend entries that way. I'd definitely recommend trying to find a way to add them to your trading if you can...
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Actually David the Double Top you point out brings up a common "fear" as shown in hind sight in that chart. It does sell off a bit, but then turns into a Triple Top and then really gains down momentum for a good full "short". I know you see this, but just thought I'd point it out.
I use no indicators at all. First few years after I started learning to trade my charts looked like christmas tree with all the indicators. Today all I do is wait for price action triggers inside daily trends off support or resistance depending on direction I need.
Good ol' David Waring. Need to send him an email or something. Haven't communicated with him in a coon's age.
Great video, especially the second half of it
Stochastics has it's place. Can keep you from getting into a position when you should wait. But this video is bang on. Don't use it like retail ...
DO watch the trend
DONT trade every cross of stochastics
DO only watch the general direction ...
DONT tie it to markets that are correlated to expansive economic metrics
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Technical tools don't really give you much of an advantage over everybody else. That's why the market will always be a mystery, even to the smartest investors. The point is, know that you are going to lose 3 times before you may 1 gain. The key is to make that one gain bigger than those 3 losses combined. That's the biggest secret you'll ever learn when trading.
Could you just explain the 3 numbers that make up the stochastic?
In this case 14,3,5
Is 14 the number of periods use to make the calculation for %K?
You state that the 5 is the period MA of %K which gives us %D
I just don't understand what the 3 means.
I hope you can help
Hello. Great info. I noticed you show a 6-month+ range. How effective are these indicators at smaller time frames? One week, daily? I noticed on basic trend charts on Yahoo, etc. that the values show up differently.
thanks for all your videos. They are well organized and clear.
I want to know who these "pros" are everybody talks about. I've been on trading desks of two major investment banks and they scoff at macd or stochastics. The only indicators I've seen them use are moving averages
4:09 Sorry but when you talk about crossover signals this is hard to follow. Apparently you're talking about two (2) singals but your graph only shows one (1). Could please enlarge your chart so we can actually see what you mean by "cross above" and "cross below"?Thanks in advance.
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