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How to Use Stochastic Indicator.
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First Look at the Stochastic Indicator. The stochastic momentum index (SMI) can indicate when a trend is strong (for entry points) and when a trend is weak (for exit points). This lesson looks at the stochastic indicator, which is another momentum indicator and oscillator. As a reminder, an oscillator has a theoretical range from 0% to 100%, but the action zones are above 70% or 80% and below 30% or 20%. Whether you take the more extreme values depends on the characteristics of the stock you are trading, and you need to look back over the chart to see what may work best.
The stochastic oscillator works from calculations on where the closing price is in relation to the daily range. If the uptrend is strong, and therefore has momentum, the closing price will tend to be towards the upper end of the range, and vice versa. It can be very powerful, and 20 years ago was almost regarded as a holy grail by traders.
As an oscillator, you can expect in a steady trend that it will go to an extreme value and stay there, so merely being at that value does not signal a trade. You may even choose to use the technique given in the last lesson on the RSI, and wait for a retracement in a strong uptrend to cause the oscillator to hit the lower value before considering a trade.
One of the interesting features of the stochastic indicator is that there are two lines plotted below the chart. On a black-and-white chart the solid line, %K as it is called, is the actual oscillator line, and the dashed line, %D, is a signal line. The signal line is simply a three period moving average of %K, which means it has a smoother profile. If you’re using a colour chart, you will be able to set the colours that work best for you.
As the name suggests, the signal line helps in determining when to enter and sometimes exit the trade. Just as the moving average crossover on a price chart can give you a signal, the signal line on the stochastic indicator can give you a trading signal. Simply look for it to cross the oscillator line when in an overbought or oversold area on its way back to the other end. The video gives several examples of this.
There is a further refinement of the stochastic indicator. The particular indicator we have been talking about is called the Fast Stochastic. Some traders use what is called the Slow Stochastic, which takes the Fast Stochastic %D, calls it the new %K, and takes a further moving average to generate another %D. The Slow Stochastic smoothes out the variations further, which generally means it gives fewer later signals, but may reduce the number of false signals.
As with all oscillators, it is important not to mechanically place a trade simply because of the position of the line. You need to assess the situation and determine, preferably using other methods, whether it is a likely trading situation. No one indicator can give you a reliable trading signal without considering other factors.
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