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How To Use Stochastic Ideally

Two New Indicator Patterns In Automated Market

Stochastic is a true oscillator, meaning it was designed to track Overbought/Oversold conditions. That means it works ideally in a Sideways or Trading Range Market Condition, and fails during a Trending Market Condition. Oscillators help retail traders identify areas where a turn in a stock may occur. Most true oscillators have two horizontal lines on the chart to show the Overbought and Oversold levels.

The term "oscillate" comes from physics and simply means to move between a high and a low point on a regular basis. Stocks in wide sideways patterns tend to follow this kind of pattern.

The Overbought Theory makes many assumptions. The Theory is founded in the concept that as a stock moves up in price there will come a time when the number of buyers begins to diminish, as price reaches a point where everyone who wanted to buy the stock is now fully vested. So there are no more buyers or insufficient buyers to move the stock price up further.

The Oversold Theory is just the opposite. As a stock declines in price, there are insufficient sellers to move the stock down. Fewer and fewer traders or investors want to sell their stock.

Overbought and Oversold conditions are different from profit taking. We have far more profit taking on the short term trend in our current electronic marketplace than George Lane had in his more traditional buy-and-hold-for-decades marketplace of the 1950's.

It is important to understand the Market Condition under which this indicator was designed. George Lane developed the Stochastic indicator as he saw the Trading Range patterns in the market of his time. He wanted to create an indicator that would track the Overbought/Oversold patterns, to signal when a stock was about to turn on the short term trend up or down. The reason Oversold and Overbought conditions are critical in Sideways markets is that the shift from buying to selling can happen rather quickly.

George Lane's theory for the Stochastic formula is based upon the presumption that as a run moves up a stock will close at or nearer to its high, as Velocity aka Volume and buyers increase. When momentum tapers off or buyers become scarce, then a stock will close lower from the high price for the day. As the days continue the stock closes lower and lower each day creating the turn from the Overbought level seen in the Stochastic indicator, which traditionally signaled that the stock was about to move down.

Once you understand the basic theory of Stochastic and George Lane's interpretation of the market conditions at that time, his reason for creating the indicator and his formula theory, it becomes easier to see what Stochastic can and can't tell you about the stock price action in the near future.

Most Stochastic indicators have a pre-defined 80% Overbought line and a 20% Oversold line on the chart. The indicator Relative Strength Index RSI typically is preset for a 70% and 30% oscillation. RSI tends to be smoother than Stochastic, and also tends to give a more accurate reading for the long term trend as long as the analysis timeframe is not too extended.

Stochastic has a very specific use. It doesn't perform well for several price action patterns.

Chart example #1 below is a Weekly view, with RSI in the middle chart window and Stochastic in the bottom chart window for comparison.

Chart #1 Weekly view

With the crossing of the two lines, Lane's Stochastic gave a "signal" during a market when few stock charts were available and even fewer analysts knew how to interpret price action. Since line charts were prevalent and bar charts were just beginning to gain popularity at that time, Stochastic gave a means by which traders of that day could enter on a crossover signal.

Nowadays, using Stochastic alone as an entry signal can get you into serious trouble. Since Lane's Stochastic was created for the short term trend price action, don't try to use it for long term analysis. Use it with a Daily to 3 Day view, but don't assume it will function optimally on Weekly or Monthly chart views for the long term trend.

In the Weekly chart view above, both oscillators are showing Overbought conditions when they should be indicating that the stock is in a Velocity move. Neither Stochastic nor RSI in this format is giving information needed with respect to what price is going to do next. Stochastic signals the move up out of the bottom low late, while RSI starts moving up from its low in the bottom early.

Chart #2 is another example of when the basic interpretation of the indicator does not work well for the price action.

Chart #2 Daily View

During tight Consolidation patterns, Stochastic fails to Peak and Trough to signal Overbought and Oversold conditions. Trading systems that use red light/green light signals for entries and exits, get false trigger entry and exit signals during this kind of price action. This causes retail traders who depend on these kinds of entries and exits, to suffer many losses due to whipsaws.

At the end of the rectangle drawn, Stochastic signals Oversold yet the stock fails to move up sufficiently for a good profit and actually moves down further. Then Stochastic signals an Overbought condition just before the blast off running gap, so a retail trader using Stochastic for this stock would miss out on the big gain. This happens a lot with retail traders who use Stochastic based on the simplistic view of buying when it crosses on the bottom 20% line, and selling when it crosses on the top 80% line.

Below is chart example #3 where a stock started out in a "Floating Stochastic" pattern on the downside, and shows Stochastic working and failing. "Floating Stochastic" is my term, and won't be found in any technical analysis books.

Chart #3


The stock was downward trending rapidly. Then it shifts to a sideways pattern where Stochastic never gets into the Overbought area, indicating that more downside is likely. Peak after Peak it fails to reach Overbought conditions. Then it moves deeply into the Oversold area before turning upward, and moving into a floating pattern at the Overbought zone.

Below in chart example #4, Stochastic signals Oversold to Overbought conditions well during the bottom, but forms a floating pattern as the stock runs in a strong upward trending pattern. This is one of two new patterns in the automated market of today.

Chart #4

Floating Stochastic patterns occur when the stock is moving with Velocity. Basically Stochastic is totally failing, but this can be a pattern that IF you understand, can tell you the stock has moved from a sideways to a trending pattern. These floating patterns can last for quite a while, as long as the stock is trending up. The key to using this floating pattern is to recognize the shift from a sideways bottom to a trending upward move.

Chart example #5 below shows "Higher Lows" as a stock moves to complete a bottom, which is another new pattern.

Chart #5


This new pattern for Stochastic occurs during a Bottoming or Topping phase, using "Higher Lows and Higher Highs" or "Lower Lows and Lower Highs" that can form in the oscillation pattern of the indicator. These often signal a change of trend or the completion of the bottom or op. These patterns can often help with choosing stocks for a Watchlist during bottoming phases.

Summary

Stochastic has subtle nuances and patterns and works ideally in extended periods of Trading Ranges, really wide Platforms, wide W Triple or Quad Bottom formations, and all range bound sideways price action. You know that Stochastic is working properly for a chart when the lines move between the Overbought and Oversold lines successively, which is a successful oscillation pattern.

Most traders are told to use Stochastic as an Overbought exit or sell short signal, and an Oversold entry or buy signal. This simplistic approach worked well prior to the 1990's and the advent of electronic trading plus massive institutional trading activity. However this is far too simple an approach for the faster paced more dynamic and complex marketplace of today, where short term trading dominates more than ever.

It will form a floating pattern as stocks move with Velocity or start Trending Upward steadily. You can also use the "higher lows" pattern for bottoms getting ready to move up out of the sideways action, and "lower highs" for tops that are getting ready to move down out of the sideways topping pattern. Changes for example in price action and Volume signal big gaps, and runs are coming as a Bottoming Market Condition completes. Do not try to use Stochastic for tight Consolidations as it will hover in the middle of its chart and give false signals.

Remember that Stochastic does not contain all of the data necessary for proper analysis of stock price action. It doesn't factor in Volume at all. Without Volume, you really are analyzing half of the equation. So add a Volume indicator to your indicator set-up, for confirmation of the signals you use in the Stochastic indicator.

I invite you to visit my website at www.technitrader.com

Trade Wisely,

Martha Stokes CMT

Chartered Market Technician
Instructor and Developer of TechniTrader Stock & Option Courses

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Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.