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Indicators and Oscillators: Stochastics and MACD, Forex Trading
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Stochastics is a range-based indicator with the readings set between 0 percent and 100 percent. It is otherwise referred to as a momentum oscillator indicator. George C. Lane is credited with creating the formula. His indicator is a popular technical tool used to help determine whether a market is overbought, meaning prices have advanced too far, too soon, and are due for a downside correction, or oversold, meaning prices have declined too far, too soon, and are due for an upside correction. It is based on a mathematical formula that is computed to compare the settle ment price of a specific time period to the price range of a specific number of past periods.

The theory is based only on the assumption that in a bull, or uptrend ing, market, prices tend to make higher highs and the settlement price usu ally tends to be in the upper end of that time period's trading range. When the momentum starts to slow, the settlement price will start to fade from the upper boundaries of the range, and the stochastics indicator will show that the bullish momentum is starting to change. The exact opposite is true for bear, or downtrending, markets.

There are two lines that are referred to as %K and %D. These are plot ted on a horizontal axis for a given time period on a vertical axis from 0 per cent to 100 percent. This is what the stochastics formula measures on a percentage basis where the closing price is in relationship to the total price range for a predetermined number of days. There is a fast stochastics and a slow stochastics category for most trading software programs. The difference is in how the parameters are set to measure the change in price, which is referred to as a gauge in sensitivity. A higher rate of sensitivity will require the number of periods in the calculation to be decreased. This is what “fast” stochastics does—it enables one to generate faster and higher frequency trading signals in a short time period. The fast stochastics setting is best for short-term forex traders. The formula to calculate the first component of fast stochastics using a 14-period setting for %K is as follows:

%K = c - Ln/Hn - Ln * 100

where c = closing price of current period

Ln = lowest low during n periods of time Hn = highest high during n periods of time

n = number of periods

The second calculation is the %D (3-period). It is the moving average of %K.

%D = 100(Hn/Ln)

where Hn = the n period sum of (c - Ln).

What is important when using stochastics as a trading tool is under standing the rules of how to interpret buy or sell signals. When the readings are above 80 percent, when %K crosses over the %D line, and when both lines are pointing down, a “hook” sell signal is generated. A confirmed sell signal is triggered once both %K and %D close back beneath the 80 percent line. The exact opposite is true to generate a buy signal: When %K crosses above %D, when the reading is below 20 percent, and when both lines are both pointing up, a “hook” buy signal is generated. A confirmed buy signal is triggered once both %K and %D are crossed over each other and then close back above the 20 percent line.

Markets need volatility in order to move, and we need markets to move in order to trade. We also need to base our trading plans on reliable signals. Setups that trigger an entry don't always work perfectly; therefore, if we have a better understanding of the markets' overall condition or trend direction, then we can apply and use the tools more effectively. I like to ex ploit the strengths of each trading tool to the best advantage. In order to do so, I need to understand what constitutes their makeup and what strengths or weaknesses these trading tools have. I also use them with more than one confirmation factor, such as pattern recognition, location of prices in relationship to pivot support and resistance levels, and also the phase or con dition that the market is in.

Stochastics can be integrated with several techniques, from the Elliott wave to simple trend-following tactics, to help you identify opportunities and to help filter better setups and triggers. Understanding that market gy rations move in cycles or phases is another form of pattern observation. Prices move from trend to consolidation and back to trend. Figure 5.1 shows that prices tend to consolidate then trend but also can cycle from highs to lows to highs again within certain periods. I believe that traders get caught in bull and bear traps because they are constantly forming bullish and bearish opinions and fail to realize that while they could be correct in their market predictions in the long term, it is the timing of their entries within these cycle highs and lows that chops them up.

These cycles can often gyrate between support and resistance levels, otherwise referred to as sideways channels, or bounce intraday between the predicted pivot support and resistance levels. Using what we have cov ered already to capture clues for shifts in momentum with the stochastics oscillator, we have the aid of using candle patterns, especially the high close dojis (HCDs) and low close dojis (LCDs), moving average crossovers, and pivot point analysis. These are confirming signals that may corrobo rate where a turning point might be in the market and help better time an entry or exit for a trade. The stochastics oscillator might help you see what condition the market is in from a perspective of a cycle high period or cycle low period.

Figure 5.2 shows other confirming signals to corroborate the stochas tics trading signals. It might benefit you to see if the methodology works in a diverse group of noncorrelated markets. When you test to see how robust or how well a signal responds in different markets, if there is a higher percentage of positive outcomes in various markets in different time periods, then this should help validate the reliability of that signal, which in turn will help you be more confident and give you an edge in your trading. Notice that the high close doji and the moving average crossover corresponded to the stochastics hook buy signal; then as the market reached the projected pivot resistance and as a doji candle formed, the stochastics warned of a bearish divergence. This would give a trader ample warning or confirma tion to either tighten stops or exit the trade.

Figure 5.3 is a spot forex euro currency that demonstrates the same setup and trigger that would enter a long position with the %K and %D crossover above the 20 percent line with a confirming higher closing high candle pattern. The sell signal also works well as confirmed when %K and %D both cross over and close back below the 80 percent line. Stochastics helps traders find when the market makes cycles from highs to lows and back again.

The beauty of stochastics is that the formula measures the rate of price change or the momentum of the price movement; when prices are in an up trend or bullish mode, the close tends to manifest toward the highs. Once this variable starts to fade and prices close closer to the lows, it will warn you that there is a change in the market condition. Prices will cycle from low to high and then back to low. The exception to this is when the market is in a strong trending condition, leading the stochastics indicator as an in effective tool.

One other method in which to use the stochastics indicator is trading with a pattern called bullish convergence, as shown in Figure 5. 4. It is used in identifying market bottoms. This is where the market price itself makes a lower low from a previous low, but the underlying stochastics pattern makes a higher low. This indicates that the low is a “false bottom” and can resort to a turnaround for a price reversal. Market prices can and usually do vacillate around the actual pivot point number before making a decision on a directional price move. It is at these points, or market conditions, that you want to use an indicator to help measure the true strength or weakness of the price action. That is what the stochastics indicator does. In Figure 5.4, we see how a secondary low is marked with a higher indicator low. Once we draw the corresponding lines, it appears as if prices and the indicator are actually converging. This is hinting that the secondary low is not as bearish as it seems and that a market rally can occur. In essence, this is ex actly what happens; and as prices trade above both moving average values, we have a nice trigger to go long for a quick profitable scalp.

Another signal is a trading pattern called bearish divergence, shown in Figure 5.5. It is used in identifying market tops: where the market price makes a higher high from a previous high, but the underlying stochastics pattern makes a lower high. This indicates that the second high is a weak high and can resort to a turnaround for a lower price reversal. The chart shows how the market makes a secondary high, but the corresponding high in the stochastics is at a lower level than the primary high point . This pat tern can alert you that if the market appears to be ready for a new bull trend, the stochastics readings should be equal to or higher than the pri mary peak level. Likewise, a higher high that is accompanied with a lower stochastics reading indicates a potential trend reversal, especially when prices are near a pivot resistance level. Notice the lower closing low off the secondary peak and that %K and %D both cross over and are beneath the 80 percent line. This helps confirm the sell signal that was triggered with the moving average crossovers and the lower closing lows. Bearish divergence signals warn you that there is an impending downtrend of a substantial amount. Therefore, it is important to monitor for divergence patterns.

The bearish divergence pattern signals or forecasts that there is an im pending reversal in prices and that one is ready to occur. As I mentioned previously, you can get ready to place an order to act on the signal; but you should not act until the confirmation of a lower closing low triggers the entry, which is on the close or the next open. Here are four rules to guide you to trading a stochastics bearish divergence pattern:

1. The first peak in prices should correspond with a peak in the %K and %D readings above the 80 percent level.

2. The second peak should correspond to a significant higher secondary price high point.

3. If the secondary stochastics peak is less than or under the 80 percent level, this signals a stronger sell signal.

4. Prices should make a lower closing low to confirm a trigger to enter a short position. Enter on the close of the first lower closing low or the next open. The protective stop should be initially placed as a stop close only above the high of the secondary high.

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