Using Stochastics in Technical Analysis
If you talk to people who trade or you browse some internet trading forums, you will encounter two types of traders: those who think Stochastics is a great tool and "works" and those who think that Stochastics is "useless" and "doesn't work". Now you probably want to know which ones are right. The truth is that both and none. As everything in the markets, Stochastics sometimes works and sometimes it doesn't.
Overbought-Oversold Doesn't Work in Trending Markets
Like other oscillators, if you trade Stochastics in the overbought-oversold way (betting on trend reversal), you will likely find it successful in sideways markets, oscillating markets, and markets with no strong trend or direction.
On the other hand, in a strongly trending market, you see Stochastics overbought at 95 and you go short but guess what? It remains overbought and market makes new high on the next bar. And the next... It is difficult to short a strongly bullish market – it can be very rewarding when you get the moment right, but very costly when you don't – and most often you won't.
Moving Average + Stochastics
Some traders face this issue by combining Stochastics with a trend-following tool, typically a moving average. The trading strategy looks like this (we're now talking about trade entries only):
- Buy when Stochastics is oversold, sell when Stochastics is overbought (classics).
- When there is a trend, only take the Stochastics signals in the direction of the trend. E.g. in an uptrend, buy when Stochastics is oversold; but when Stochastics is overbought (which is most of the time in an uptrend), do not take the signal and stay out.
- Trend is defined using a moving average, e.g. there must be 10 bars in a row when price closed above the moving average for a valid uptrend. Alternatively you can use two moving averages and define a trend as the faster moving average having been above or below the slower one for N number of bars.
- When there is no trend, take Stochastics signals in both ways as usual.
You Never Pick a Big Reversal, But You Can Ride Trends
This approach is good because it filters out many losing trade signals. But with this approach one thing is sure: you will never pick the exact reversal point of a big trend (when the market is topping, your moving average is still showing an uptrend, which means shorting forbidden).
On the other hand, if you figure out a way to stay in the good trends after your entry, you can have some really big winners. This strategy has a potential for working both in sideways and trending markets. But unleashing its full potential naturally needs a lot of fine tuning and experience, especially on the trade exits part.