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Warning!!! Stochastic Indicator - Mutton Dressed As Lamb

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I was an eager trading upstart with a few trading profits from the dot com boom way back before the year 2000.

 

I chucked in my job, sold my printing equipment and researched day and night to find the system to be the next George Soros.

 

Does this tale sound familiar?

 

Of course 3 weeks in I had found the answer, stochastics. I couldn’t believe how wonderful it looked as my eyes caught the signals generating the start of amazing trends. Why hadn’t anyone else seen how much money was available in trading pullbacks. The private jet was just around the corner. Maybe I could buy Christopher Skase or Alan Bond’s used one!!!

 

So after adjusting my Stochastic settings to my secret formula (I think I moved the K period to 11), off I went to trade for a living. Now the reality did not quite fit the TV ads of me with my laptop by the infinity pool watching my account grow. I was watching signals on my large (for late 1990’s) 15 inch screens hitting the stochastic cross and then not magically going up like it should. Sometimes it would move lower, sometimes it would chop and every now and then it would move higher. Many times as I moved to a profit I would move my stop to break-even and then get stopped out. Eventually after a few losses I would take off the stop altogether and bail for a large loss just before a reversal where the market would shoot up. We’re now in 2013 and I look at markets a lot differently to back then. Market structure and corrective phases are what I focus on in my trading and how I teach clients. My view is that trading using stochastic or other momentum indicators in isolation creates fairly random outcomes without an understanding of the bigger picture.

 

When we look at indicators our eyes often skip the failed trades and lock in on the successful ones. System developers often see this bias when evaluating and back testing potential ideas.

 

Let’s review the 6 stochastic signals from an entry perspective on a Euro chart (attached below) and then look at it with a focus on market structure points.

 

Signal 1 came after a weekend gap up and deep correction. Both this first area and the Signal 2 setup could have produced nice returns if traders had wide stops in place and managed to second guess the Fed meeting where price zoomed up.

 

Signal 3 produced an entry after the vertical move up. There was very little follow through and would have been difficult to produce a positive outcome.

 

Signal 4 had a little downside follow through but failed to trend strongly.

 

Signal 5 had no follow through and failed and signal 6 failed after moving a few points to the downside.

 

With trading the stochastic indicator in this example there is a conundrum. Take large stops to get the occasional out-sized winner but lose more on each loss, or take small stops and often get stopped out before a big move comes about. There is nothing wrong with using a momentum indicator but it needs to be in context with the market dynamics. Trading the first bounce after an exhaustive vertical move (Signal 3) is a different structure to trading the 2nd retracement of a range bound market (signal 2).

 

I have developed an understanding of market structure to improve my trading and believe it is essential to create a lasting edge.

 

Here is a few key structure observations which have provided me an edge when trading:

 

The Gap and Trap. Point “A”

 

Gaps are often exhaustive in nature, when they occur after a trending move. Over optimism has buyers entering the market at a price point where there is no-one on the sidelines willing to bid higher. Usually we see a small impulse move above the open high before traders start accepting lower prices. This is a key setup for me after a positive profit announcement and a prior run up in price and at times where there is an optimistic crowd. My job as a trader is to identify where the upward momentum stalls and capture a low risk entry as selling commences. Price in this instance moves in the path of least resistance. Think about this – If there are no more buyers on the sidelines willing to trade a higher price, no matter how exciting the news is the price cannot move higher. And as the first traders start accepting lower prices to close their positions it forces other traders holding a long position to contain losses and sell creating a snowball effect.

 

Pump Fake. Points ”B”

The pump fake is defined where price action thrusts above support or resistance and then reverses, moving back within the prior range that has developed. These spikes tend to shake out stop losses and set up break out traders positioned on the wrong side, forcing them to close their position and effectively adding to the price reversal. I have marked in 3 areas with a “B”.

 

Tip. Have a look at the stochastic at each of these “B” points. The crossover at each had nice follow through. Combining momentum and structure will improve trade selection and timing.

 

Key Message

 

Working off specific zones that trap traders is a way to counter-punch. In boxing the counter punch when an opponent is off balance is a deadly weapon. Catch traders that have committed to a trade and capture profit as they acknowledge the dynamics have changed by reversing their positions.

 

Contrary dynamics that surprise the majority are what creates directional movement.

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