How Day Traders use the Stochastics Oscillator for Range Trading
One of the most popular momentum indicators in Technical Analysis (TA) is the Stochastic oscillator, developed by George Lane. Just pull up any stock or futures chart and place a Stochastic study on it. One will quickly see how good it looks and why it's so popular. At a glance, it would seem that this indicator catches all the turning points very well and is the "holy grail" of TA. Sadly, on the contrary, as many a daytrader who has blown his account will know, the pretty picture does not reveal the whole story.
What is the Stochastics Momentum Oscillator?
The Stochastics oscillator is a smoothed and normalized momentum indicator that has set lower and upper boundaries of 0 and 100. It consists of two lines: %K, which measures the relative position of the current close within a price range defined by the user, and %D, a three day average of the %K line that functions as a signal line. When %K crosses above or below %D, a market turn is implied. For a more technical discussion, go to Stochastics Oscillator at Wikipedia.
Stochastics generate several types of trading signals, the most important being:
- divergence, specifically between price and the %D line as the most important signal
- overbought/oversold signals and divergences,
- penetration of the %D line by the %K line, while both are in the overbought/oversold zones
It must be noted that there is another version of Stochastics called Fast Stochastics. It is commonly calculated over a five-period but due to the noisiness of the raw %K and %D lines, the more traditional version is usually used by software programs like Quotetracker, Ninjatrader and eSignal. This standard version is simply referred to as Stochastics.
Major Common Mistakes When Using Stochastics
One of the biggest mistakes made by traders is not realizing that the Stochastic oscillator is a momentum indicator and NOT a trend following indicator. Even in its default settings of 14-periods, Stochastics can potentially still be very noisy and generate many false signals. This translates to getting a trader out too early during strong trends and potentially re-entering another trade against the dominant trend. The other pitfall unknown to many is that Stochastics can remain solidly in oversold territory for long periods during downtrends and conversely stay in overbought zones during strong uptrends.
How Professional Day Traders Use Stochastics
Since Stochastics is a momentum indicator, it is best used when the traded instrument is in a trading range. The challenge therefore is to first determine if the instrument is in a strong trend or in a trading range by using appropriate technical indicators for the job like MACD, ADX or Bollinger bands. A visual method in identifying trading ranges is when both breakouts and breakdowns fail to follow through and the market trades back to within the range. Once it is identified that the market is in a trading range, Stochastics will give excellent signals, especially using divergence and crossover signals.
Beyond just trading within ranges, Stochastics can also be useful in getting traders to time their entry and exits during strong trends. A wise trader will first determine the dominant trend using a higher time frame e.g. 5-minute chart on say the ES, NQ or YM futures contracts. Once a dominant trend has been identified using trend indicators, price action or trend lines, Stochastics can signal entry points during retracements using a lower timeframe e.g. the 1-minute chart. The basic rule is to buy or cover short positions during downward retracements during strong uptrends and conversely, sell long positions or go short during upward retracements during strong downtrends.