I’ve looked at Stochastics a number of times in Trader’s Bulletin, but today I really want to get to grips with this very popular indicator, because there are many ways to use it – some of them extremely useful, but some of the most common methods are downright misleading.
Stochastics are in the family of momentum indicators. As all good school children know, momentum comes into play when something is speeding up or slowing down. And market prices are very rarely steady. Instead, they move in fits and bursts, swinging up and down. When we look at these ups and downs, it can be tricky to make sense of the movements – and this is exactly when stochastics can help.
What Stochastics do
To understand what stochastics are telling us, it’s helpful to think of this reading as a measure of the rate of change. The indicator looks at the range of previous candles over a period (the default period is the last 14 candles) and measures the current closing price against these.
If we’re at the top of that range, the Stochastic will read 100%. If we’re at the bottom of the range, stochastics will be 0. And any movement in between will fall in that 0–100 range.
If we remember that’s what Stochastics do, then it’s easy to see how an uptrending market can sit close to a 100 level for a long time, and a strong downtrend can give very low readings for a long time.
In the example above, we can see that each new, lower candle, pushes the 14-day range lower, and that the price is repeatedly near the bottom of this range, giving very low Stochastics readings for several days.
You’ll often hear people tell you that Stochastics are an ‘overbought’ / ‘oversold’ indicator, but when you look at images like the one above, you can see how useless a tool that is.
Yes, there are times when an overbought or oversold reading can help us … but this is probably one of the lamest tools in the Stochastic armory.
I want to show you much more powerful ways to apply Stochastics
We’re not interested in Stochastics readings that are stuck high … stuck low … stuck in the middle …. Instead, we’re interested in how our Stochastics are moving.
This tells us that prices are accelerating or decelerating in a direction, giving us a clue that this move is breaking out … or that the current trend is running out of steam.
In the example below, we’re looking at a strong move from the Stochastic, and the two Stochastic lines (the second line is a smoothed out, moving average of the first), crossing and moving apart. This is a great clue that the price movement on the chart has serious momentum behind it, making it worth jumping onto.
Next, we’ll look at an example of a strong trend, where Stochastics seem stuck in overbought territory, but we won’t let this panic us into a sell. Instead we’ll wait until the Stochastic gives us a clear sign that the trend is dwindling.
The signal that we’re looking for is the Stochastic indicator making a lower high, while the price makes a higher high – this is called divergence, and tells us that the trend could be reaching exhaustion.
Now is the moment to watch for a range forming, and look out for the breakout pattern we saw above.
Be dynamic with your Stochastics
I urge you not to think of Stochastics levels as a static thing – don’t worry too much about whether it’s over 80 or under 20 … just ask yourself what is it telling you about price momentum.
Is the market about to shoot off?
Or is it about to settle down?
With just a little practice, you’ll find that reading Stochastics for momentum is very intuitive and powerful.
Used right, this can be one of the most successful indicators – we just need to know how to harness its power.