Stochastic is one of my favorite indicators. It began as a forex trading tool but has since been adapted to trading all kinds of financial assets. The theory behind the indicator is fairly complex, it is based on random walk/Brownian theory type analysis. It assumes that daily price action is completely random but that over time you can plot that randomness and determine longer term trends. Think about it like this: A man is walking his dog down the street. The dog is on a leash and randomly swings from one side to the other as the man is walking. It is impossible to know where the dog will move to from one minute to the next but we can use the limits of the dogs movement to track the general direction the man is moving.
What is Stochastic?
Stochastic – The word stochastic derives from the ancient Greek word for aim. The pattern of holes made by a machine gun burst is stochastic in nature. We know in general where each bullet is heading but where they end up is completely random. Check out my stochastic for binary options review if you don’t know what is it.
How Does Stochastic Work?
Stochastic is an oscillator, if you don’t know what that is read up on that for homework. The indicator uses two lines, %k and %d. The shorter term %k is the dog and the longer term %d is the man. By studying the way the oscillator ripples and creates peaks and trough you can determine trends, entry and exit points. Stochastic works well in any time frame and with other indicators. Stochastic can give a variety of signals but this strategy focuses on only the trend following signal.
How Does the Geek Simple Stochastic Strategy Work
This strategy uses two time frames and only takes trend following signals. Additional analysis includes basic fundamental analysis (is this asset good, is it going up or down?), trend line and long term support/resistance. Start with a 5 year chart of weekly candles. Draw support and resistance lines where they look appropriate. This can be very subjective and takes some practice. Usually any peak, trough or congestion band could be a long term support or resistance. For trend lines join any two consecutive peaks or troughs and extend them to the right. This can also be subjective but I tend to draw my lines through the tip of the lower or upper candle wicks. This chart will now set your long term trend and trading direction, only trade with the long term trend. On this chart the Semiconductor Index is trending up with a strong stochastic buy signal. This is your signal to move down the the daily chart and look for an entry.
- Long Term Signal – In an uptrend the long term signal occurs when the %k moves above %d. The strongest signal occurs when %d is moving up as well. Once the initial signal is taken additional signals occur whenever %k dips and then points back up.
The Buy Signal
The buy signal will occur on the daily charts. Since the weekly analysis is bullish I am looking for a bullish signal. Any bearishness on the chart is to be considered a buying opportunity unless the longer term signal changes. Since there is no upper resistance on this chart we can assume no reversal is eminent at this time. When I move down to the one year chart of daily prices we can see that the last buy signal from the weekly chart is coincident with a move down to the support of the up trend line, a really good entry point. Since we have missed this entry we will look for the next one. The signal here is the same. First look for possible areas of support or resistance and then draw your lines. The SOX is above support but stochastic is extended at this time and rolling over. This is the time to wait. Allow the trade to unfold, stochastic will give you a signal. Price on the SOX may trade up, down or sideways. It will find support or fall through it. Stochastic will tell you when to get in. The weak signal occurred just before the long term signal fired, the next daily signal will be the strong one. Wait for the stronger signal and then make the trade.
- The Buy Signal – The buy signal looks just like the signal on the weekly charts. The difference is the time frame. The long term signal tells you what to buy, the daily signal tells you when to buy. In an up trend anytime the %k moves up above the %d line is a signal for a call. The reverse is true in a down trend. If the asset, in an uptrend, is nearing resistance use an option with an expiration of only a day or two. If there is no resistance then a longer expiry, up to several weeks, can be used.
Why this Strategy Doesn’t Suck
This strategy doesn’t suck for a couple of reasons. First it utilizes multiple time frames. Multiple time frame analysis is one that I and others here at BOTS think very highly of. It also utilizes trend analysis and follows the old adage of “trade with the trend the trend is your friend”. It also doesn’t suck because it is a simple and reliable way to trade. It is also a great foundation for deeper analysis as you gain knowledge and experience. Stochastic works well with all kinds of other technical analysis techniques and can also give other types of signals besides trend following.
Why this Strategy Might Suck
This strategy might suck because trading is hard, being profitable is hard and waiting is hard. Having the patience and discipline to wait for a trade is something that few traders have, that is why there are so few truly successful traders. This strategy also has some limitations. It is a bit of a lagging indicator, signals often come after a large portion of the move has already taken place. Also, if the underlying asset is in a trading range strong signals are not as strong as if the asset were trending.
How To Build On This Strategy – Final Words
There are at least two good ways to build on this strategy. First learn more about stochastic analysis. Learn how to look for divergences and other early signs of reversal. This will help you get into new market moves earlier than just using the trend following techniques. The second way is to incorporate Fibonacci Retracements. Use them to confirm the support and resistance lines you have drawn. Anywhere a Fib converges with one of your lines is a great place to find a market reversal.