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RichardCox

Trading with Dual Stochastics

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Trading with Dual Stochastics

 

Many many new traders first get into the field of technical analysis, there is a good deal of terminology that must be mastered relatively quickly -- or at least before any real-money trades are actually placed. This terminology includes that long list of indicators and oscillators that have risen in popularity over the last decade. It seems as though a new indicator type of presenting itself every few months as traders attempt to develop new strategies for gaining an edge and increasing profitability when using technical analysis approaches.

 

One of the stranger sounding names in the oscillators category is the Stochastics oscillator, which is a technical trading tool that tends to have more users in the realm of forex than in any other asset class. As a quick reminder, the Stochastics oscillator is a gauge of momentum that relates closing prices in an asset to its range of price activity over a specified period of time. Most traders tend to use the default settings when the Stochastics oscillator is made available on the trading station, but there are some alterations that can be made in the oscillator depending on the type of signals that you want to receive. Specifically, the oscillator becomes less sensitive to new price moves in the market when the time period is adjusted or when traders instead plot a moving average of the Stochastic readings themselves.

 

In most cases, the standard formula is used to calculate the Stochastic reading, and this formula is shown below:

 

%K = 100[(Closing Price - 14-period Price Low)/(14-period Price High - 14-period Price Low)]

For those less mathematically inclined, this results in a final reading that will allow traders to assess whether the price of the asset has become overbought or oversold. Definitions for both of these characterizations differ in some circles: Aggressive traders view readings below 30 as being oversold where 70 and above suggests the asset has become overbought. More conservative traders tend to wait for more extreme signals and use 20 and below as the criteria for oversold readings (along with 80 as the threshold for overbought signals).

 

The underlying logic for the Stochastics calculations is that prices tend to close near their highs when markets are in an uptrend (and close near their lows when markets are experiencing downtrends). Some charting stations show the Stochastics reading as a single line (the %K line). Other charting stations will add another line (the %D line), which is essentially a 3-period moving average of the reading shown in the %K line.

 

Establishing a Dual Stochastics Strategy

 

Now that we have an understanding of the basic calculations and logic that is behind the Stochastics oscillator, it makes sense to start developing new ways of using the indicator. This is the only way that traders can truly gain an edge on the rest of the market, where the exact same signals are being sent to everyone using these indicators and oscillators with their default settings.

 

One alternate way of using Stochastics is to combine a fast Stochastic with a slow Stochastic and then to identify areas where each indicator moves to opposing extremes. This dual Stochastics trade can generate many signals that are not readily apparent to those that are basing Stochastic strategies on the default methodology. In this case, the 80% and 20% thresholds will be used, as these offer better extremes and reduce the number of false signals. We will also be using a 20-period EMA as an additional trigger signal that is used to validate any potential trade ideas that might be identified. This EMA is not completely required for the dual Stochastics system but there are some added advantages that can be captured when putting this extra trading indicator on your charts.

 

When setting up your indicator parameters, the following settings can be used: The slow Stochastic calculation is based on a %K of 21, Slowing parameter of 10, and a %D parameter of 4. The fast Stochastic calculation is based on a %K of 5, Slowing parameter of 2, and a %D parameter of 2. For the slow Stochastic reading, the “signal line” field is used and the “main line” field is left blank. For the fast Stochastic reading, the “signal line” field is left blank and the “main line” field is used. If you are using the Metatrader platform, this is how the platform should be configured for the slow Stochastics:

 

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This is how the platform should be configured for the fast Stochastics:

 

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For each of these Stochastics lines, you will want to use different color lines, as this makes it much easier to spot trading signals as they unfold. For actual trading criteria, there are some additional rules that should be remembered when using the dual Stochastics strategy:

 

  • Prices should be in the midst of a strong trend (in either direction)
  • Stochastics readings for both lines should extend to opposing extremes
  • Wait for a retracement to the 20-period EMA and a supportive candlestick formation that indicates short-term reversal before entering into the position
  • Some traders will use the mid-line in the Bollinger Band indicator rather than using the 20-period EMA

Next, we will look at some examples of the dual Stochastics strategy at work. For the most part this strategy is employed on the middle time frames (ie. 1-hour charts) but the same rules can be applied to longer time frames, as well.

 

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In the example above using a chart history in the USD/CHF, we can see two different price points that could be used for new trade entries. The forex pair has started to generate a strong series of higher highs and higher lows, which meets the first criteria for new trade entries using the dual stochastics strategy. In both cases, prices break above the 20-period EMA and then fall back to test the supportive effects of the indicator.

 

As this occurs, there is an extreme difference seen in the activity of the fast and slow Stochastics as one of the indicators falls into oversold territory while other other rises into overbought territory. Adding to the bullish bias are the candlestick formations that are seen as these developments occur. In both cases, doji candles are followed by bullish engulfing candlestick patterns. Added information on the engulfing candlestick pattern can be found in this article.

 

In this example, we can see that the extreme differences between the slow and fast Stochastics created a precursor that signalled the larger bull rally that followed, and the two potential entry points shown in the example above would have generated significant profits if identified early. “Significant differences that are showing simultaneously between short and long term indicators suggest that the early-stage trend activity is likely to continue,” said Michael Carney, trading instructor at Teach Me Trading. “These types of differences can be used as a basis for new positions when there are additional indicators confirming the position.”

 

In this chart example, we can see the bullish case that is based on the arguments in the dual stochastics strategy. If an initial downtrend was present the same rules apply, only in reverse. The important part to remember here is that opposing signals must be sent by the dual Stochastics readings, as this ultimately suggests that the initial trend is likely to continue. In this way, the dual Stochastics strategy should be viewed as a continuation structure and that probability for success are greater when one or more additional factors (EMA activity, candlestick patterns, etc.) are present.

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