How To Use The Stochastic Indicator
Not what you think
The stochastic indicator is very popular and a lot of beginners are drawn to it for its clear “Over-bought” and “Over-sold” signals, but a lot of them don’t know what it actually indicates.
The stochastic indicator ladies and gentlemen…
(Source – TradingView)
In the above picture, we can see that the stochastic is scaled from 0 to 100. No matter how crazy price moves, these two boundaries will never be breached. The basic idea is that when those two lines exit the highlighted part into the 80-100 zone, price is “Over-Bought”. Similarly, when those two lines exit down into the 0-20 zone price is “Over-Sold”.
Now here’s the kicker. I just told you that no matter how far price moves, those two lines will stay within that 0-100 boundary. Meaning? That even in an extended uptrend, the indictor will continually show you that the market is in an “Over-Bought” condition.
Conversely, in an extended downtrend, it will always show you that the market is “Over-Sold”. If you’re planning on buying when the indicator reaches “Over-Sold” or selling when it reaches “Over-Bought”, you will be slaughtered in trend moves (which is where you want to make most of your money).
How to trade Stochastics
The stochastic indicator is a MOMENTUM indicator. Not a Trend indicator. So you would erroneous in trying to sell when a Momentum indicator is showing you Bullish momentum (Over-Bought). Perhaps this will help you see what the picture looks like.
(Source – TradingView)
In Example 1 we see how at each of the yellow lines, the stochastic indicator was “Over-Bought” and price continued moving upwards and IN FACT seemed to move ANGRILY against any sellers. The market hates traders that disagree with it. The Stochastic was not showing you “Over-Bought” conditions. It was showing you “Over-Bullish” conditions. So this shows you why some stochastic traders wouldn’t know a bullish market if it slapped them in the face even though that’s exactly what the stochastic tells them.
I want to point out something else in this example. Pay attention to how any time the stochastic went into “Over-Sold” there was barely a retracement in price. This is your sign from above, if you were looking for one, that bearish momentum is weak and you should be anything but a seller right now. Be a buyer, be a spectator, be an ostrich with its head in the ground for goodness sake.
And finally, where the green line appears, price was actually “Over-Bought”. If you were still mentally and emotionally able to pull the trigger, your sell would’ve paid off. Don’t yourself in a position to only win 1 in 4 Trades. That’s not how you become a profitable trader. Following the common logic that means you would be buying all the way down which, I’m convinced you can see would be a bit, if not very, silly.
Don’t bet the farm.
Don’t lose your shirt.
Cut the L.
Keep the W.