As with most indicators, trades should always be taken in the direction of the primary
trend to ensure the highest probability of success. In the above chart of ACW we
see that from early February to mid April that prices are in 2 month down trend.
Traders using the slow stochastic would have been able to avoid selling at short
term bottoms in late February and mid March as the oscillator signalled oversold
conditions. Astute traders would have traded in the direction of the trend by shorting
ACW in early April.
Stochastic oversold signals should be used to add long positions during pullback
in prices during up trends. In the daily chart of Cerner Corp we see the uptrend
clearly defined as prices are trading above both the 50 and 200 day simple moving
averages. High probability trades would be to add long positions on pullbacks or
pauses in the uptrend. The red arrows identify overbought conditions signalled by
the stochastic oscillator.
Divergence in direction of the stochastic oscillator and direction of prices on
the daily chart provide strong indication that the prevailing trend is about to
In the daily chart of Abbot Laboratories, we see in December of last year that prices
have made a series of higher lows suggesting that ABT was in an uptrend. Traders
who were watching the slow stochastic would have noticed that even though price
was making higher lows that momentum was slowing. This was signalled by stochastic
lines making lower lowers. This divergence right before price of ABT traded 47.50
to 44.50 in only four trading sessions.
In the weekly chart of the Dow Jones Industrial Average we see that in the last
quarter of 2009 prices continued to make lower lows. In the meantime the stochastic
line was making higher highs signalling that the down trend was about to come to
an end. The INDU index proceeded to bottom in March of 2009 at 6500 and trade up
to 12500 in the next 2 and half years.
One of the biggest mistakes made by novice traders is to take contra trend positions
when oscillators move into extreme readings. In the above chart of Exxon Mobil we
see that oscillators can remain in extreme readings for extended periods of time.
Many traders refer to this as a “stochastic pop”. Prices “pop”
out of a consolidation range and begin a new trend. If the trend is strong enough
we can see the stochastic oscillator have extreme readings for long periods of time.
In November of 2010 XOM was trading sideways between 68 and 71 dollars. In December
XOM broke out to the upside when prices closed about 71. Exxon Mobile went on to
trade from 71 to 88 in the next four months. We see that in this entire four month
period that the stochastic oscillator was overbought. The stochastic pop is a good
reminder for traders to always to trade in the direction of the primary trend.
The stochastic oscillator is an excellent tool to identify overbought and oversold
trading conditions. Like the majority of technical indicators and overlays, they
should never be used in isolation to make trading decisions. Trader will find that
they will have the greatest success when using oscillators in conjunction with other
indicators. One thing that will forever be true is that price is always the final
arbiter and those traders who ignore this do so at their own peril.