Stochastic indicator is widely known among traders to be used to indicate a market asset being over bought or oversold. It was Dr. George Lane who had developed this indicator during 1950s. It describes the current price level in relation to the price range within a given time period. Hence the term over bought when the Stochastic Indicator shows current price level above 70 and over sold when current price level is below 30. Since it is able to describe the price level such a way that there is a possible turning point, why do traders hate it so much? Or is there any misunderstanding between traders and the indicator?
The Problem of Stochastic Indicator
Every trader have their way through trading the market at their preferred methods. Some traders go for the long term with swing trade, some traders look into short term profit with day trade, and there are a lot of traders who are attracted to the shorter term scalping method. With proven trading strategies, which ever methods are being used, trader are being deemed profitable as long as they are the master in their trading skill.
As being part of trading strategies, technical indicators are being used to analyse and filter the market condition. Traders are relying on technical indicators to time their entry. But, what not when one trader is using Stochastic Indicator, at most of 7 out of 10 times of trading entry being made are not good entries, especially for those who are scalpers and day traders.
Scalpers
This group of traders will find it horrific using Stochastic indicator as the time frame that they trade ranges from M1 to M15. The high fluctuation and uncertainties of the market causes the indicator to be unreliable. Just look how M1 stochastic describe EURUSD in a short period trending market structure.
The default setting of Stochastic which are:
- %K Period: 5
- %D Period: 3
- Slowing: 3
provides the least possibilities of lagging information derived from the price movement. However, inexperience traders may take the wrong side of the trade though believing that scalping with a 2.5 pips trade would be profitable. The truth is, I've been there before and it is not a consistent profitable trade. Imagine your risk ratio is 1:1 where you are risking 2.5 pips stop loss to a 2.5 pips profit at a 30% chance of profit rate. Your losing trade still out performs your profitable trades.
Day Traders
Day traders who uses stochastic as trade entry indication by taking buy entry when the indicator crosses above 30 and sell entry when the indicator crosses below 70 may survive what scalpers are worried of, but not for long. As the market makes a sideways structure, day traders can easily profit from H1 to H4 time frame. The downside risk of such strategy is that once the market pick a side, day traders will face the same problem as the scalpers. Imagine that being a day trader, the stochastic indicates possible trend reversal, crossing above 30, but a stronger bear is pushing the price down even though the indicator not being able to reach up to 50.
Day traders may find some sweet spots to trade base on the market structure shown above. However, let alone by using Stochastic indicator itself is not enough to describe the market condition as a whole.
How Should Stochastic Indicator be Used?
Though I would disagree that Stochastic Indicator is useless, Stochastic Indicator is just not fit for being a trade entry indicator. It tells traders potential of market turning point but to an extend that at times it just failed to do so, not that the market or the indicator is wrong, but it is the limitation of the calculation developed by Dr. George Lane.
It would be unfair if Stochastic Indicator were to be blame for its short coming. A combination of technical indicators may assist Stochastic Indicator to tell a full story of what's the market to be. As for my favorite combination would be Bollinger Band and ADX paired with Stochastic Indicator on a D1 time frame. Even though for me as a day trader, having a D1 time frame allows me to pick up the big picture of the market as to where it would move.
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The 17 Proven Currency Trading Strategies by Mario Singh is one of an eye opener for me to improve my trading style by going through the "Trader Profile Test". In another words, if you DO NOT KNOW whether you are a scalper, day trader or a swing trader, you will want to take the test to define your trading profile.
Besides that, this book also teaches you Forex hedging strategies used by many professional traders at multinational corporations.
