The Stochastic Indicator for Swing Trading

How do you decide when to exit a winning trade?

How about timing entries into new trades? Are you finding better results trading breakouts or pull-backs?

The current market has frustrated many talented swing traders. The general market continues to make new highs yet active trading seems to be a challenge.

Signs of an Experienced Trader

One of the hidden secrets of great traders is the ability to pay attention to the types of trades that are not working. They quickly notice when their odds are not getting follow-through. Experienced traders will notice this before a new trader because new traders generally do not commit to a strategy and a set of tactics.

This makes having a “feel” for the trading environment tough. It’s tough to attain this insight when you haven’t committed to a strategy. Experienced traders will use this knowledge  to make adjustments.

They lower their risk parameters until they can determine; if they re not trading well or if they are trading well and the market conditions are changing. The amount of time, money and stress this saves is enormous.

How the Stochastic Oscillator Solves this Problem

First a definition: “stochastics” are a technical momentum indicator that compares the closing price to its price range over a given time period. In other words the oscillator measures if it is closing near the highs or lows.

The concept behind this indicator is that in an upward-trending market, prices tend to close near their high, and during a downward-trending market, prices tend to close near their low. Readings that are significant are the “20” line and the “80” line.  When the indicator is rising toward 80 and ultimately goes through, the security is considered over-bought. The prices have reached an exaggerated  level of buying in the upward price action.

On the opposite end of price action, The indicator begins to move lower (prices are closing near the lows with consistency) and nears the 20 reading of 20. If the stochastic reading goes below this level it is considered to be over-sold and the odds of continuing lower in a meaningful way are reduced.

** Be careful!

Over-bought and over-sold are indicators, not absolutes. They are readings that indicate probabilities. Never buy simply because the reading is under 20 or sell/sell-short because the reading is over 80. This condition can remain in for long periods of time and may lead to either a reversal or a continuation.

Think of it as more like an alarm as opposed to a signal. The signal comes when the reading actually reverses!

When the stochastics reverses and moves below the 80 line or above the 20 line this is the time to take action.

We are going to apply these readings to:

  • Identify a trend to trade.
  • Identify entry signals.
  • Identify Exit Signals

 Trends

One key mistake many traders make is identifying an edge on the same time frame they use for entry signals. This is like driving 55 but never looking past your windshield. You don’t know the environment. The stochastic indicator has two lines which display the readings. They are %K and %D or a fast and slow oscillator.

Today’s lesson is to use stochastics to identify the trend on a higher time frame and ONLY trade in that direction until the trend has changed as described above. You will continue to ignore any potential entry signal that is not a buy signal. This may sounds like “Captain Obvious” is speaking but we all know the dreaded ego speaks at times and we listen too often.

Keeping your edge clear and simple makes it easier to follow.

Entries

When you wait for a pull-back to enter you get a very easy area to spot to manage risk. Breakouts are exciting when they follow-through, but in today’s computer driven world there are more false breakouts that trigger trades that are difficult to manage.

Trading stocahstic readings that dip below the 20 line (for a buy entry on your entry time frame) prevent you from jumping the gun on a stock that is falling (although in a longer term uptrend).

There are many reasons for early entries but the biggest one in my opinion is the desire to not miss a trade. We nibble before the time is right and before we know it we are kneed-deep in a bad entry in a great trend. The reading dipping below 20 is not the actual buy signal. The signal is when it rises and closes above 20 (Again, to be clear-in the direction of a higher time frame rising stochastic that is not above 80)

Exits

Exits are a tricky subject because they must be put into the context of your strategy.

Are you a trend trader holding for the big move? Are you planning to hold during inevitable declines in site of what your “paper profits” are?

Or do you consider yourself a momentum trader who plans to “ring the register” when prices move in your intended direction? Either way the proper method for using the stochastics for an exit is to wait for the reading to move above the “80” line for a long and consider selling when the reading closes below.

One word of caution abut exiting too soon. An 80 reading is an alarm and the alarm can remain overbought which would increase your profits. As with the entry side of the trade, be patient to wait for the alarm but don’t take action until the signal.

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