Fast Track Stochastic: For discussion, the nuts and bolts of trading the Stochastic Indicator in any market and any timeframe are presented herein at the request of Beth Shapiro, organizer of the Day Traders Meet-Up Group, Rockville, MD. Thanks Beth. These notes are provided by Richard Stephens, CEO, Horizon Capital Management Group, LLC, an experienced and professional trader and reflect his personal understanding and experience. Richard can be reached at Email: ceo.horizoncapital@gmail.com Due to time considerations, these notes are provided in advance and intended to be reviewed and discussed at the Meet-Up meeting, August 19, 2008. The Stochastic Indicator is an oscillator that tracks the market over-bought and over-sold conditions comparing price close relative to the price range over a given time period and when set up correctly, will provide a leading indication of market reversals; The formula as we know it today originated from a trading partner of George C. Lane and is based upon the formula to mix limestone with concrete; this gave way to an insight that provided the modification that now formulates the indicator. Three numbers are required, %K, %D, and a period slowing usually 3; The main line is called %K. The Second line, called %D, is a Moving Average of %K. The %K line in this presentation is depicted as a segmented line. Typically, the indicator utilizes two lines, the %K and the %D, although in some cases a third line is provided. This presentation is based upon only the two lines. %D can be described as the deviation from the Normal and is the slowed and smoothed result of %K calculations; Stochastic is the process of finding the underlying pattern in what appears to be random or chaotic market movements; It is a momentum oscillator that measures the velocity of price movement and always changes direction before the price changes direction when properly formulated to the market you are trading; Based on the observation that as price decreases the period close tend to accumulate ever closer to their extreme lows of the period range and conversely, as the price increases, the close tends to accumulate ever closer to the extreme highs of the period range; Stochastic indicator can be used in conjunction with any time period, however a top down review of the market you are trading, monthly to at least one period below the period you are trading is recommended. To understand your position in the overall market you can and should utilize and have a working understanding Copyright 2008 Richard L Stephens Jr. Fast Track Stochastic Page: 1
of the Eliot Wave system, this will help you identify periods in which you should pyramid your position, take profits, or exit and reverse; Stochastic and RSI are similar in nature but the Stochastic was perfected in 1986 to provide a better and/or cleaner indication of entry and exit signals; Major sell moves are best identified by Divergence at the top of the period; Major buy moves are best identified by Convergence at the bottom of the period; Setup of the Stochastic Indicator is determined by the number of Bars in a Time Period cycle that you are trading, two consecutive cycles are added together then divided by 2 to reach an average of the cycle (average down to the next whole number), Divide that number by 2 and round down, this calculation will give you %K (the greater the number of bars the smoother the indicator); Period, A to B and B to C are counted, then averaged and rounded down to the first whole number (use the swing low candles as A, B, & C points); When properly structured, the Stochastic is always a leading indicator, never a lagging indicator. Rules: Go Short when the Bearish Divergence is confirmed; Go Long when the Bullish Convergence is confirmed; Identification of these two situations is illustrated on the next page: Copyright 2008 Richard L Stephens Jr. Fast Track Stochastic Page: 2
When a stock or commodity has made a high, then reacts and subsequently goes to a higher high while the corresponding peaks on the Stochastic make a high, then a lower high, a Bearish Divergence is indicated; Conversely, when a stock or commodity has made a low, then rallies and subsequently moves down to a lower low while the corresponding low points of the Stochastic have made a low, then a higher low, you have a Bullish Convergence ; Copyright 2008 Richard L Stephens Jr. Fast Track Stochastic Page: 3
Note: in the case of a bottom the down trending arrow based on price and the up trending arrow of the Stochastic will, if extended, CONVERGE while at the top the two arrows will never converge, they are DIVERGENT; Always watch for the Convergence and Divergence signals and for the 3 drives to a top and 3 drives to a bottom that is common in most market actions as seen in the Bull Convergence chart above; Signals: The signal to act on Divergence comes when the %K line crosses on the RIGHT HAND SIDE OF THE PEAK OF %D in the case of a top; The signal to act on Convergence comes when the %K line crosses on the RIGHT HAND SIDE OF THE LOW POINT OF %D in the case of a bottom; Stochastic Indicator is NOT a good tool in a Runaway Market; In a down trending market when the stock or commodity is reacting against the major trend, one can expect Congested Bottoms and conversely, the same congestion can be seen in a similar situation in up-trending markets; Copyright 2008 Richard L Stephens Jr. Fast Track Stochastic Page: 4
When a short reversal down trend is broken and the stock or commodity is returning to the major trend or in the case of a break in a consolidated market, Stochastic will provide an inverted V or spike top; Take profits when %K rises above 90%, or when %K crosses above %D, or on completion of a pattern of Convergence, the reverse is true for down trending markets. Make sure you remain attentive regarding the possibility of a congesting indicator during a trending market, in such cases, when congestion is possible, utilize a trailing stop and let the market take you out; Copyright 2008 Richard L Stephens Jr. Fast Track Stochastic Page: 5
Crossovers: A Left Handed Crossover is caused by a reduction in the velocity of the movement in %K over %D (bull or bear) and usually indicates a reversal of trend for the next period (watch for spikes); (Charts below are sequential) A left handed crossover occurs when a change in trend rapidly occurs usually when a short reversal trend is returning to the major trend. This predicts that the market has more to go before giving the correct Right Hand Cross Signal; Copyright 2008 Richard L Stephens Jr. Fast Track Stochastic Page: 6
Warning: When %K has been trending each period and then one period reverses sharply, this is a warning that you may have only a few more periods before a reversal, this is noted in periods above 70% and below 30% on the indicator, don t confuse this with the Knee move in mid chart; When %K reaches the extremes, 0% and 100% this denotes extreme strength in the market and does not denote a top or bottom in the trend and usually signals the beginning of a Stochastic Poop or period of indicator congestion. If the Stochastic settings are correct, the %K will usually just touch 100 and retreat, if it stays at 100 for more than 1 period, your settings may need adjusting; Copyright 2008 Richard L Stephens Jr. Fast Track Stochastic Page: 7
In a market returning to the major trend, the short, interval and long term trends are all up (i.e. the 21, 49, 89 MA s are stacked); then when the %K reaches 75% of the over bought level, then price is frequently only half way to it s high and you can double the move from the start of the up move to the 75% mark to arrive at a first target price for the move, in addition, this is a good point to add to your position (my personal rule of thumb is no more than 4 positions in any one stock or commodity move); Conversely, in a bear trend move, when %K reaches the 25% mark of the down trend you may have as much as 50% to 90% of the down price action to go, double the price move from the top to the 25% mark to identify your first price target; Copyright 2008 Richard L Stephens Jr. Fast Track Stochastic Page: 8
If after the %K crosses the 75% mark, the market reverses, use the %D s move to the 60% mark as an indicator to sell if you haven t already exited the trade; Notes: The 3 drives to the top or bottom was a market phenomenon first identified by Tubbs in the early 1930 s and was a Pre-Elliot Wave Technician; Some traders, the author included, will take trades at the cross over, which means, when %K goes above %D and crosses from the top down, a short trade is taken. When %K goes below %D and crosses from the bottom up, a long trade is taken. Exit when the reverse occurs. Copyright 2008 Richard L Stephens Jr. Fast Track Stochastic Page: 9
Below is a chart showing Bill Williams Fractals in use, per my email of Aug 20, 2008: Note: I moved my hard stop to point A in the above chart, essentially half way down the big candle since the market was moving fast and there were no new Fractals to be seen. Copyright 2008 Richard L Stephens Jr. Fast Track Stochastic Page: 10