A funny thing about trading is that what one person sees as a strongly trending market another person sees as an overbought market that is ready to reverse. This is actually a good thing because as long as people have different perspectives on the market, there will be someone to buy when you want to sell. Knowing when the market is about to turn and when it will be sticking to its trend is a hard thing, but by knowing how to use momentum oscillators such as stochastics and the relative strength index (RSI) properly, one can gain an edge.
I find oscillators to be an important part of my trading, but many people use oscillators without knowing how to use them correctly; others don't even look at them. When used properly, they can be an invaluable tool for a trader. As a piece of the trading puzzle oscillators can inform a trader a lot about market activity, including trend direction, the strength of a move, and potential reversals. Oscillators are helpful in timing entry and exit points and can show traders when they have overstayed their welcome. By using them correctly, one's chances of trading successfully will increase. Oscillators work great at picking tops and bottoms in choppy markets, and when combined with trend-following strategies in strong markets, they can help you time your entry into and exit out of the market. This will help a trader catch strong trades near the beginning of a move and get out of them before the tide turns. As you will see, there are many different ways to use oscillators, and each person has to find the method that best fits his style.
There are several different oscillators one can use, such as stochastics, the relative strength index (RSI), momentum, moving average convergence-divergence (MACD), and price oscillator, and they each have different features; however, they pretty much all look and work the same way. Chart 7—1 shows several different oscillators, and you can see that they all seem to move together. At Points A, B, C, and D they are all bottoming, and at Points E, F, and G they are peaking. Oscillators are indicators that, unlike the market, have a range in which they travel. As opposed to trends, trendlines, and moving averages, which travel with the market, when an oscillator hits the top of its range, it has nowhere else to go. A stock can keep going higher forever, but an oscillator stops at its boundary. Once an oscillator hits its limits, it can either stay at the top or start coming off, but it can't go higher. In Chart 7—1 you can see how the indicators go back and forth between either the 0 to 100 range or around the zero line regardless of what the stock does.
CHART 7—1
60-Minute KLAC: Looking at Oscillators
Oscillators basically reflect the speed at which prices change. An oscillator works by comparing closing prices for any given time frame, using previous closing prices to determine whether the market is gaining or losing momentum. As a market gets stronger, prices tend to close near the top of the bar. When prices make successively higher and larger closes, an oscillator will rise. When prices stop going up as fast, stop making larger highs, and stop closing near the top of their range, an oscillator will begin to stall and show signs of the market being overbought. The market may still be going higher, but when the strength of the moves has slowed or remains constant, an oscillator begins to stabilize and fall. You can see how at Point A on Chart 7—2, the market was still strong but the highs stopped getting higher. This caused the stochastics to start turning down, which preceded the market getting weaker. The market doesn't always come off when the oscillator hits an extreme; instead, the oscillator can stay near its extreme when the market is in an extended trend, as it was in the downtrend from August to October before Point B or between Point C and Point D. During periods like these one needs to stick with the trend and use the oscillator as a way to confirm a strong trend in the market. This is easier said than done, because it is hard to figure out when the market will trend or reverse.
CHART 7—2
Daily EBAY: How Oscillators Aren't So Clear
Before getting into some of the individual oscillators, I want to point out some of the basics for reading and using them. First of all, an oscillator normally sits at the bottom of a chart and either ranges between 0 and 100, or oscillates around a zero line. If it ranges between 0 and 100, there will be an upper line and a lower line which represent the overbought and oversold zones (Chart 7—2). These lines usually are placed at 70 to 80 on the overbought side and at 20 to 30 on the oversold side. Once the indicator has reached these areas, it increases the odds that there will be a stall in the trend or reversal. If it reaches these levels and turns, it is reflecting price action and can confirm a directional change in the market, whether a reversal or a slight pullback. When the indicator is in the overbought-oversold area, a trader should start thinking about taking profits or scaling out of a piece of the position if he is already in the market. If he is looking to get into the market, he should use the overbought area as a place to wait for a retracement if he wants to get long or as a place to get ready to make a trade from the short side. Oscillators that revolve around a zero line may not have predetermined upper and lower limits; one has to look at a chart to determine where they may be. With these indicators the zero line plays an important role in determining when momentum changes direction. Although different markets have different sets of parameters that work best and although each market may change over time, I like to keep things simple and use the basic parameters for all my markets and time frames. I normally use the canned look-back periods because this is what everyone else is looking at and I don't want to be late to the party or get caught anticipating a move that doesn't happen. For example, when using stochastics, I normally stick with the 14, 3, 3 parameters that most software packages use. I don't need to get fancy and try to find the best parameter for every market. I'm happy with what everybody else is looking at. Besides, it is the concept of the oscillator that is important to me, not the actual parameter that works best. The next few sections describe some of my favorite oscillators.
SELF-FULFILLING PROPHECY In my opinion the reason oscillators can work so accurately is that they represent a self-fulfilling prophecy. If traders everywhere are looking at the same indicator and it falls to an oversold level, people will start covering their shorts in anticipation of a bounce. As they do that, the market begins to rally just a bit, turning the oscillators up. Now more people see this "signal," and so they begin buying and the market starts to rally accordingly. If the signal is real, the market will continue to rally; if it is false, the market will go back to its prevailing direction. |
My favorite indicator has to be stochastics. I have stochastics on every chart I use whether it's a 1-minute or a weekly chart. I use it because I like to see the momentum of the market, whether it is in overbought or oversold areas or still has room to move. I've been looking at it from my first days of trading, even before I really knew what it did or how it worked.
When I was first on the floor back in the late 1980s, there were a few computers scattered around the pits that all the traders shared. I went to look up a chart of crude on a CQG terminal and noticed that someone had left the stochastics indicator on. I liked the way it looked, and so I kept it on. At first I didn't really know how to use it correctly; I just liked the way it always seemed to turn at market tops and bottoms. But as I learned to use it, it grew to become an important part of my trading. When I ignore or misuse it, I find I get hurt by either chasing the market or getting out too quickly or at the worst possible time.
Although this is probably one of the most widely used indicators, most people who use it don't know what it does, how it is derived, or how to use it properly. They use it because it is so popular and seems to work great in predicting market tops and bottoms. Though there are both fast and slow stochastic indicators, the slow one is the one most generally used and the one I'll mention.
The slow stochastic indicator consists of two lines: the %D line and the %K line (dotted in my charts). The %K line measures where in relation to the last five periods the current close is; what you see plotted as %K is a three-period moving average of %K. The %D line is a three-period average of the smoothed %K line. Though there are two lines in the stochastics, the %D line is more important as it is smoother and more stable than the %K line.
SLOW STOCHASTICS FORMULA %K= 100 × (C — L(5)) / R(5) Then take the average of %K for last three periods to get a slowed version %K. %D= 3-day moving average of %K C= last close L(5)= low of last five periods R(5)= range of last five periods |
The stochastic normally is plotted underneath a chart with values ranging from 0 to 100. Overbought and oversold areas typically range between 20 and 30 for oversold and 70 to 80 for overbought; 20 and 80 seem to be the standards. I typically use 25 and 75 as my overbought and oversold lines because that way it will include more signals.
The stochastic oscillator measures a market's most recent close relative to its price range over a specific period of time. The theory is that in an upward-trending market prices tend to close near their highs, and during a downward-trending market prices tend to close near their lows. As the market gains upward momentum, the closes will be at the top of the range and the indicator will be getting stronger. As the trend peaks, the indicator should be at its highest levels. Once an uptrend begins to slow, prices will tend to close farther away from the high of the bar, and this will cause the indicator to turn. Even if the trend is still up and the market is making higher highs, it can be losing momentum if the closes are not near the highs of the period anymore. This will be seen in the stochastic indicator as it stops going up and begins to turn down.
The gray ovals in Chart 7—3 show a typical example of this. During the wave up, the market was strong and the closes were near the top of each 5-minute bar. As the market went up and the closes were strong, the stochastic indicator got stronger until it reached the overbought level. Eventually the market stopped making higher highs but stayed near the highs, going sideways. At that point the indicator began losing strength because the closes were not as strong anymore, and it turned lower soon to be followed by the market.
Though one can use stochastics in different ways, many people have only a limited understanding of how to use them. The only way most novice traders end up using them is to buy when the stochastic indicator reaches oversold levels and turns up or to sell when it reaches overbought levels and goes down. Though this works in choppy markets, it may not work well when one is trading against a strongly trending market; it also is not how the stochastic indicator was intended to be used. Using stochastics to pick overbought or oversold areas is just one aspect of using them. Since there are many subjective ways in which stochastics can be used, it can become confusing to use them if you are purely a mechanical system trader, but more on that later.
CHART 7—3
5-Minute S&P 500: Stochastic Ideas
Look at Chart 7—3 for the following examples and take note that when I mention buying, you can assume the opposite for going short. For now I am ignoring multiple time frames and the long-term trend, but they are still important and I will get back to them.
This is one of the most basic trades when one is using stochastics. When both lines are moving in a clear direction, are rising toward the overbought area, and are above the oversold level as in the two examples labeled 1, you can catch waves in the market by getting onboard. The lower the indicator is when you get in, the more potential the market has to keep moving. If the lines start rising below the oversold area, be sure to wait for the lines to cross above it before taking the trade. In a choppy market these trades can be very profitable from both sides of the market; in a trending market it is best to take them on the side of the trend and use a crossover in the opposite direction as a signal to exit or stop yourself.
This is a typical and very common crossover signal. When the fast line (%K) crosses over the slow line (%D), it suggests a buy, but be wary of false signals with crossovers. The cross of %K over %D could be above or below the oversold line, with the ones that happen below having the most potential. Be sure to wait for the line to cross above the oversold area before getting involved, as this is more of a confirmation.
The signal is stronger when the crossover comes after %D bottoms and not before it. Most of the time %K will turn sooner than will %D, but when it turns after %D, it is a stronger sign of a change in direction. Example 2 shows a typical crossover of the two lines. In a strong trend like the one in this example, the lines may not always reach the oversold area. Regardless where it takes place, this is normally a sign of a move in the direction of the change.
Example 3 demonstrates how a trend can continue even after the market reaches overbought territory. The fact that the market is overbought does not mean the trend will stop dead in its tracks; there may still be plenty of room for the trade to continue. This is what makes oscillators tricky: Sometimes the overbought area can mean the market will turn, and other times it means the market is strong. As long as the indicator stays above the overbought line, one should be long, especially in a strong trend. As an exit or stop, one can get out when both lines dip below the overbought territory.
A strong trading opportunity comes when the indicator moves into overbought territory, prices pull back a bit, and then the indicator retests its extreme, as in Example 4. Though similar to Example 3, this is a better trade, as the market tried to pull back but couldn't. The indicator staying by its high indicates that a strong trend is under way. Sometimes the stochastic can sit in overbought territory indefinitely as the market keeps going. Many traders either miss the move or get hurt trying to fade it. Again, as long as the indicator stays above the overbought line, one should be long, especially in a strong trend.
I'll use a short for this example. Many times after they've been in overbought territory and topped, the stochastic lines will start to drop, but the drop appears to fail as they turn back up again. If on this upturn the lines can't completely cross over and start going back up, one could go short. In Example 5 you can see that the market tried to rally back up, but the %K was not able to turn back up above the %D line; this failed attempt to reverse is a great place to short the market. Even though it is against the current trend, the failed move in the indicator and the small risk to the highs if you are wrong can make it a rewarding trade with low risk.
The failed move doesn't have to happen after a peak in overbought territory or a bottom in oversold territory. It can happen any time both lines change direction, and then the faster %K line turns back but stalls at the %D line without crossing it. When this happens, it provides strong confirmation that the initial move was good. In Example 5a you can see how after both lines turned upward, the %K line made a small move down, hit the %D line, and then turned back up. At this point it indicated that the market was still strong. For an exit one could use a clear reversal in the stochastics.
Probably the most effective and least used method of using stochastics is looking for a divergence between price action and the indicator. I'll discuss divergence in more detail later in this chapter, but for now, if you see the market making lower lows while the stochastic indicator makes higher lows, you have divergence. When this happens, the indicator usually is telling you that the market has lost momentum and may change direction soon. The two examples labeled 6 show places where the market went lower than it had done on its last wave down, but the stochastics made higher lows as they were starting to uptrend. In the first incident it marked the beginning of a 3-day up move, and the second time it marked the lows of the day.
Like stochastics, the relative strength index (RSI) is a momentum indicator that measures the price of a stock or future relative to itself over a fixed period of time, normally 14 bars, again on a scale of 0 to 100. It shows the ratio between the periods that closed up and those which closed down over the lookback period. Though 14 is the most common lookback period, you can use different lengths, causing signals to vary. The shorter it is, the more volatile the indicator will be and therefore will produce more signals; a larger lookback period gives fewer but more reliable signals. Like stochastics, the RSI is used to see when a market is overbought, is oversold, or has the momentum to keep going. When a market picks up steam and the RSI gets closer to a top or bottom, there is always a good chance that the market can retrace a little of its move. But be alert, because it may show an overbought signal just as the market is about to break to make newer and newer highs.
Most people use the RSI to signal overbought or oversold areas when it goes above the 70 to 80 area or below the 20 to 30 area. Traditionally, buy signals are triggered at 30 (the oversold line) and sell signals are triggered at 70 (the overbought line). I like to wait to see it start to turn up above the oversold line before buying, as a break above 30 is more of a bullish signal than is being in oversold territory. I've included a more range-bound section of the S&Ps for some of the RSI examples as a way to see oscillators in action in different market environments. The four examples labeled 1 in Chart 7—4 show the typical signal of shorting when the market comes out of overbought territory or buying when it oversold. Again, some people like to take the signal when it looks like the indicator peaks, but it is better to wait until it comes out of the extreme territories.
CHART 7—4
5-Minute S&P 500: RSI Ideas
During strong markets the RSI may not dip down to the 30 line, and so a dip to or slightly below 50 may be considered a buying opportunity. In cases like this the 50 line can be used as a support or resistance line. A retracement will often end when the RSI hits 50. There are a couple of places on this chart (the examples labeled 2) where the market had been in a bit of trend, tried to retrace, but stopped at the 50 line. One needs to be aware that the market won't always reach oversold or overbought areas. If it stops at around the halfway point, that may be a good place to enter.
Instead of the RSI being used to show overbought-oversold areas, it can be used to follow the trend. If the RSI is greater than 50, then the trend's momentum is up and one can consider only buying. In general when the market crosses above the 50 line, a buying scenario is in place; when it goes below that line, you can think about selling. The first Example 3 shows how buying the market when the RSI breaks above 50 can put you on the right side of a strong trade. The second Example 3 shows how shorting when it drops below the 50 level makes for a decent trade.
When using the RSI, one can look at the indicator the same way one would on a chart. One can draw trendlines and support and resistance levels in the same manner as one does on a price chart. The lines tend to be as reliable on an RSI chart as they are on a price chart. I've included a few examples of how one can draw trendlines on the indicator to get the direction in which to trade. In Example 4a, once a trendline has been formed on the RSI, you can buy as long as the trendline holds. Once it gets broken, you can either short or get out of a long. You also can use it to see when the indicator has moved too far away from its trendline as a place to look for a retracement. You can also look for patterns in the indicator, as in Example 4b, where the indicator formed first a double top and then a triple top. This was a level where it could not break through. Both times it reached this level and failed to break through, the market came off fairly hard. As with divergences, looking for patterns in the indicator can lead to some very good trades and help you exit the market.
Look for divergence between price action and the RSI. This is done the same way one would with the stochastics. Example 5 shows some divergence between the indicator and the market that preceded the market changing directions, following the lead of the RSI, which wasn't able to make a lower low as the futures did.
RSI FORMULA RSI = 100 — (100/1 RS) RS = Average of x periods up closes / average of x period down-closes x is the lookback period, which is normally 14. The shorter the period, the more volatile RSI will be. The average can be exponentially smoothed or regular. |
MACD is another oscillator that I use. It is based on exponentially weighted moving averages, thus giving more weight to the most recent data. It is plotted in a chart with a zero line at the midpoint of its range. Unlike the previously described oscillators, which have overbought and oversold areas, the zero line (equilibrium line) is the important line with this type of oscillator. What one looks for in the MACD is the relationship between the two moving averages: the MACD line (dotted on Chart 7—5) and the signal line, which is a nine-period average of the faster MACD line. As the two lines come close together, they are converging, and when they are moving farther apart, they are diverging–hence the name of the indicator. As the move in the market gains strength, the difference between the two lines will grow. When that strength fades, the lines will come closer together until they potentially cross. The difference between the moving averages is plotted as a histogram. This histogram acts as the oscillator and measures the divergence or convergence of the shorter and longer moving averages. As the two moving averages move away from each other because prices are rising, the MACD histogram will move up and away from the zero level. If the moving averages cross, the histogram will be at the zero level. If the lines are falling, it will be below zero.
CHART 7—5
60-Minute S&P 500: MACD Ideas
Like other oscillators, the MACD can be used to find when the market may be overbought or oversold, especially if the market is in a trading range. Since there are no overbought or oversold areas, one must visually see when the indicator is near the top or bottom of the range to find when the move may be overdone. As with other indicators, not all signals will work out this well, but when carefully used, MACD can be a valuable asset in your arsenal of tools.
In general, you should be long only when the MACD line (dotted) is above the signal line and short only when it is below that line.
This can either be seen in the averages or the histogram; if the histogram is above the zero line, it is a bullish sign as it is the equivalent of the MACD line being above the signal line. Example 1 shows how as long as the MACD line is above the signal line, one can do well being long. Taking trades against this direction is not recommended.
Stronger buy signals occur when the MACD line is well below the zero line and turns up to cross above the signal line. The first Example 2 shows a good signal that could have been taken as soon as the lines crossed after being oversold. One also could have taken a short trade at the second Example 2, where the lines cross well into overbought territory.
When the moving averages cross above the zero line, a confirmation of a buy signal is given. At this point a trader may want to add to any position he may have or enter the market if he is not already in it. When the MACD line crosses above the zero line, it means that the shorter exponential moving average (EMA) that makes up the formula is crossing above the longer EMA. This is the same as a bullish moving average crossover signal, as was discussed in Chap. 6. Example 3 shows that when the averages crossed over the zero line, the market really began to move.
Even better signals occur when the MACD indicator or MACD histogram shows divergence against prices. Example 4 shows that when the market made a new high but the indicator didn't, the move soon ended and the market had a pretty hard sell-off afterward.
You can use the pattern of the histogram to trigger signals as well. When the histogram is below the zero line, begins forming a bottom, and starts moving higher, as in both Examples 5, you can try to catch a turn early. When you are looking at a histogram and the bars are getting shorter, the momentum may be losing strength. This may happen before the lines cross or hit zero, giving you a crossover signal. Be careful because as with all oscillators, trying to anticipate a move can lead to getting whipsawed. I use these peaks and valleys in the histogram as a method of determining that a wave may be over and to start looking to either get out or reverse my position.
MACD FORMULA Fast MACD Line (dotted line) = (short EMA — long EMA) Signal line = 9-period average of fast MACD line MACD histogram = fast line - signal line TYPICAL DEFAULTS Short EMA = 12-period EMA Long EMA = 26-period EMA MACD MA = 9 EMA = exponential moving average |
One of the most helpful uses of oscillators is for timing entries into and exits out of the market better. A trader who uses oscillators can avoid chasing the market, wait for more opportune entries levels, and avoid getting out at the worst possible moment. If one can improve in these areas, one's trading will get much better. Normally, as a market trends and moves along its way, it does so in waves. As the market runs up and the indicators get high, traders will begin to feel uneasy buying at overbought levels, and this is where the market can stall or turn around. Being aware of where an oscillator is can warn you of a possible overbought condition. When the oscillator is near the high of its range, I would never consider it a good time to buy because the market has already had a move up and the odds of a pullback are stronger. It doesn't have to pull back as the trend may continue, but the odds are strong that it will. However, many traders jump into a trade at these levels without looking at any oscillators or realizing that the market may be overdone. They are afraid of missing a move, prices look strong, and everybody is talking about how much he is making, so they think it will keep going and they end up buying market highs. This is a time when traders should be thinking about exiting positions, not entering them. If the market is overbought and keeps moving higher and you miss a trade because you are waiting for a pullback, that's okay. By waiting for the oscillator to back off or give you a signal, you will be making a higher probability trade than you would by buying an overbought market, even when it keeps going higher. It takes patience to wait for the market to dip, but this patience is what makes traders good.
Let's say you want to buy KLAC and are looking at a 5-minute chart (Chart 7—6). It has just made a move up and catches your attention, and so you look at the chart and see it is at Point A. An astute trader will not buy it here; if he looks at the stochastics, he can see that it is overbought and may come off a little before continuing to go up. Even if it doesn't come off, buying an overbought market is not a great idea. Instead of chasing the stock, he starts watching, waiting to get in when the stochastics have reached oversold conditions. He patiently waits, avoiding temptation along the way, until it reaches Point B. At this level his odds of making money on the trade skyrocket compared to what they would be if he chased it at Point A. After getting in, he decides to hold until a good exit comes along, but unfortunately, he was in the bathroom at the peak at Point C. When he came back, it had started to sell off and was nearing the oversold area at Point D. This is the area where many people throw in the towel because they are seeing their profits slip away, or worse, are losing money because they actually bought at Point C. A good trader, however, sees that the indicator is oversold and will wait to see if it turns up before getting out. In this case the market rallies out of oversold territory until it hits the overbought area at Point E and struggles to stay strong. The trader then calls it quits, getting a much better price while having avoided getting shaken out at a worse level. This doesn't always work, but at least one should give the market some time to see if it bounces at the oversold area, especially when the longer-term trend is up. If it doesn't seem to bounce, a good trader will get out; those who hold on too long here never have a fighting chance to succeed.
CHART 7—6
5-Minute KLAC: Timing Trades
Many inexperienced traders misuse oscillators because they think of them as just an indicator to catch turns in the market. What most traders don't realize, however, is that oscillators weren't created to catch market turns but to be a way to see conformation in a trending market and a tool to assist traders in exiting a trade before the market turns. Yet many people associate them only with capturing market turns. The most common mistake is that people think that when the indicator is overbought, the market will go down. But as I've mentioned, in a strong market it can stay overbought for quite a while and generate many false signals. Readings above the overbought line only mean that price is closing near its high and the market is strong, not that it is about to sell off. There is a good chance that it will, but that is not something it must do. Buying or selling in anticipation of what an indicator says is not a great practice, as very often the market will keep going in an overbought or oversold environment for quite a while. It is better to wait for price action to confirm the move than to jump in anticipation of it. If the indicator stays in the overbought or oversold area for quite a while, one must ignore it and go back to basic trend-following strategies, as they will work best.
IT'S EASY TO LOSE MONEY BY MISUSING OSCILLATORS As a testament to this, I can only say that I tried using stochastics for years to try to pick tops and bottoms and that judging from my inability to make money, they don't really work when used for that purpose alone. Too many times I tried to pick changes in the market's direction at oversold levels only to watch the market continue to tank. I wouldn't get out because the market was still oversold and was "due" for a bounce. Eventually I found that oscillators work best when combined with other indicators or patterns. It wasn't until I started using oscillators more wisely that I began getting better results from them. |
One of the bonuses of momentum oscillators is that they can locate reversal points much sooner than trend-following indicators can. In a choppy market, trend-following indicators will result in whip-saw trading, but with oscillators one can pick off short-term tops and bottoms. During choppy markets, buying oversold and selling overbought situations can work like a charm; the hard part is knowing when the market is trending or range-bound. Markets trend only about 20 percent of the time, but when they do trend, they can be strong and using oscillators can be costly. Since using oscillators to pick tops and bottoms works best in nontrending markets, one can consider using the average directional index (ADX) to determine when to use oscillators more freely. A simple rule of thumb is that when the ADX is below 20, you can consider the market choppy and range-bound. A trending system may not work in this environment, and so one may want to use a system that is based on oscillators instead, as it may work better.
I have had little luck writing a system that works by using only typical stochastic signals; therefore, I use stochastics as a secondary signal or as an alert that tells me it's okay to trade in one direction or tells me that this is a good place to exit or take some of my position off. This may make mechanical system trading a little discretionary, but sometimes you need to adapt to different market environments and be able to include different market patterns and money management in your trading. A big part of using oscillators correctly is locating patterns in them, such as double tops, trends, and divergence. These patterns can be some of the best ways to use oscillators but are hard to program into a system.
Instead of trying to outguess the market by picking tops and bottoms, using oscillators to look for divergences can make for some of the highest probability trades. Besides the ones I've previously described, several types of divergences can be found in the markets. By being aware of them and knowing how to trade with them on your side, you can get a lot more bang out of oscillators. Looking for divergences is one of the best overall ways to trade when one is using oscillators. But finding them means you always have to be on the alert. Divergences are not easily programmed into computerized trading systems, and so a trader who uses them has to take discretion on his trades. Here are a few divergences one can look for.
1. The most common form of divergence occurs when a market moves one way and the indicator moves the other way. This is typically a sign that the market may have run out of steam, as the last move was not as strong as the prior one and the momentum may have left the market. When the divergences are near market tops, these can be exceptionally good trades. A good example is when the indicator is in oversold territory, turns higher and then turns back down, but fails to break the previous low while the market makes a lower low. At this point there is a good chance that the move will run out of momentum. The RSI in both examples labeled 1 in Chart 7—7 shows this pattern perfectly. The signals here marked the temporary end of a several-day sell-off.
2. A second type of divergence occurs when the market is trending down and then stays pretty flat for a while but the oscillator moves up toward the overbought level. This is a sign that the market has no momentum in the oscillator's direction and can continue its trend with force on the next wave. You can see this in Example 2, where the stock barely moved higher as the stochastics moved to overbought territory. What makes this a high probability trade is that the market did not react as it was expected to, moving up as the stochastic got stronger. As soon as it reaches an overbought condition, new shorts will be looking to jump in, existing shorts may add to their positions, and any longs may give up hope, causing a nice move in the stock. Though in this situation it took time to work, this would have been a great short, as the market never moved higher after this.
3. Normally one looks to see when the market breaks lower and the indicator doesn't, but when the opposite happens, it is a good signal as well. An example is when the market is headed lower but doesn't make a lower low and the indicator does, as in Example 3. Here both the RSI and the stochastics moved lower but the stock could not break downward. In this situation you could start looking for a change in direction, as sellers could not take the market lower when the indicator suggested it should have gone lower. This was a short-lived bounce and would not have worked well for a trader who tries to catch major reversals, but the loss, if any, was relatively small, and it gives you a good idea of what pattern to look for. It also alerts you to a place to take a profit. You don't always have to try to catch bottoms, but if you have a short position and see this pattern, you may want to at least take a profit.
4. There are times when the market is sloping upward and an oscillator is sloping downward. This divergence should be taken as a warning that something is wrong. More often than not this indicates that price is about to change direction. A good example of this can be found in the two Examples 6 on Chart 7—3. In both cases the market bottomed after this pattern.
DIVERGENCE BETWEEN STOCKS AND THE MARKET Another form of divergence that I see and use all the time is when comparing individual stocks to the market in general. Say the market is having a strong day, I'm long a bunch of stocks, and I have a nice profit. The S&Ps then make higher highs, and as they keep going up, I notice that my P&L is not getting any better. This means that my stocks stopped moving with the market. When this happens, it implies that the market may soon turn or that a different group is leading the market now; in either case I will get out of my trades. The other way to use this type of scenario is to look for stocks that just won't go up with the market and short them; this acts as a good hedge to any longs you may have. |
One of the best ways to use stochastics is in cahoots with trend-following indicators. You should always be looking to get in the market, in the direction of the main trend. First you need to establish what the trend is. Next, if you know you have a market that is uptrending and you want to take mainly long trades, the best thing to do is to look for dips in the oscillator to the oversold levels to buy. In Chart 7—8, featuring KLAC, you can see great places to enter the market at Points A, B, C, and D. The market has been in a decent uptrend during this period, but at all those points it has just sold off a bit, coming to the trendline or stalling after a drop. In each case the indicator goes into oversold territory, representing a good place to get in. As the oscillator comes out of oversold levels and heads up toward the overbought level, one can use Points Ax, Bx, and Cx as exit points for the first three trades. Ax is a really good exit signal because of the divergence between the price and indicator: As the market kept going higher, the indicator started backing off a little, indicating that the trend might have been losing steam. The other two points could be used to get out of the market when the stochastics crossed below the overbought area. You would want to exit at these times in fear of a market pullback. If it stayed in overbought levels, one should hold, as the trend may be strong. I don't recommend going short at any of these signals because they are against the trend and therefore are not high probability trades. You can see that the market doesn't give you much time to take a profit when you are right and can explode in your face when you are wrong. Remember, you don't have to take every trade; just take the high probability ones, in the direction of the trend.
CHART 7—8
60-Minute KLAC: Going with the Trend
The way I have found stochastics (like any other oscillator) to work best is to use them in multiple time frames to time trades that are with the major trend. First I'll look for the major trend by using a daily chart, the same way I did in the previous chapters. Once I have that, I'll use the 60-minute time frame to get a better picture of how much room there is left or when there may be a pullback or overextension of a wave. After knowing what direction to trade in, I'll look at the shorter time frames to find trades. If I were using the same KLAC chart, I would use the stochastics not only to get into trades but also as a way to let me know it was okay to trade in one direction or another, in shorter time frames. If the 60-minute stochastic for example, is rising, I trade only from the long side in the 5-minute time frame. Whether you plan to hold a trade for a few days or prefer trading in and out of the market, the shorter time frame will help. Using Chart 7—9, the 5-minute time frame, which corresponds to the area between Point A and Point Ax on Chart 7—8, you can time one trade after the signal at Point A on the 60-minute chart. On the 5-minute chart you can see that if one had taken Signal A when it was given on the 60-minute chart, one would have had to sit through a $2 pullback. Waiting for the 5-minute stochastic to reach the oversold area and turn up gets you into the market at a much better level. Though it didn't work immediately, it was a much better entry point, and the risk was lower. Once in, a trader can revert back to the 60-minute chart, holding until Point Ax, or a more antsy trader can make several trades during that time period by using the 5-minute chart. I've indicated some possible entries and exits with up and down arrows; remember, trades should be taken only from the long side, as long as the higher time frame is bullish. The two Point Ds, indicate that there was some divergence between the market and the indicator, and so buys at these points are extra good trades.
Since I'm on the topic of multiple time frames, I'll reiterate that one doesn't have to use the same indicators on the different time frames. Some people may like to use volume, trendlines, ADX, and RSI on the daily time frame, then MACD and moving averages on the 60-minute time frame, and stochastics on a 5-minute chart. It can be mixed up any way that gives a trader a good feel for the market.
CHART 7—9
5-Minute KLAC: Timing Your Trades a Little More
Becoming a better trader means not just using oscillators but using them to their fullest potential. Oscillators should not be used to pick tops and bottoms, instead, they should be used to trade in the direction of the major trend. When the market is in an uptrend, use the oscillators to wait for a pullback in the market; when the retracement is oversold, look to get in. One becomes a better trader when knowing where a market is with regard to being overbought or oversold. A smart trader will not rush into a trade when he knows the market is overbought; instead, he will wait for a better entry point. Similarly, he will not be scared out of a position when the market drops and reaches oversold levels. This is actually the level at which to get into a trade, not out of it as many traders do. One of the most helpful uses of oscillators is to aid you in getting in and out of positions at better levels. If you wait a little longer, there is a good chance you can get out at a better level.
Even when the market is trending strongly and the oscillator stays overbought, it is better to wait for the first pullback to get in than to chase a strong market. Of course, when there is a strong trend, one should revert back to basic trend-following indicators, as oscillators won't work as well. What is helpful is knowing where the ADX is. If it is above 30, trend-following indicators will work best. When the ADX is below 20, you can consider the market choppy and range-bound, and oscillators will work better at picking overbought and oversold conditions.
Becoming a better trader also means knowing different ways to use oscillators. One of those ways is to look for patterns in the indicator, such as trendlines, support and resistance levels, and divergences between the market and the indicator. Another way is to realize that a market doesn't have to do what the indicator predicts it should. The fact that the indicator is overbought doesn't mean that the market will sell off. It can keep going for quite a while, with you patiently waiting for it to reverse. Remember, the market does what it wants to do and not what it should do, so don't be stubborn waiting for something to happen or anticipating a move that never comes. If the market is strong, it will keep moving up despite the overbought reading. One also can improve by combining indicators in different time frames to get different perspectives and an overall better picture of the market. Overall, by using oscillators correctly one should be able to time trades a little better.
Problems of Not Using or Misusing Oscillators
1. Getting poor entry and exit levels
2. Getting whipsawed by buying overbought markets and selling oversold markets
3. Holding losers too long because you think market is "overdone"
4. Getting many false signals with oscillators in a strong trend
5. Chasing the market
6. Getting out at the worst moment
7. Not knowing when the market is overextended
8. Believing the market must follow the indicator
9. Trading against the trend, looking for reversals
10. Missing market reversals
High Probability Trading with Oscillators
1. Trade in the direction of the major trend, buying when retracements are oversold.
2. Exit trades as the oscillator is peaking.
3. Stop chasing the market by not getting involved if oscillators are at an extreme.
4. Wait for pullbacks to time trades better.
5. Use the oscillator to find better entry points.
6. Be wary of buying when the market is overbought and selling when it is oversold.
7. Use longer time frames to find out how much room is left in a major trend.
8. Look for divergences between the price and the indicator.
9. Look for technical patterns in the oscillators.
10. Look at the ADX to see when the market is in a strong trend or not.
11. When an oscillator stays near the extremes for extended periods, it is a sign that there is a strong trend.
12. Combine indicators to get confirmation.
13. If an oscillator is rising above the zero line, you should only be buying.
14. Hold on just a little longer when you can't take the pain anymore and the market is overdone.
Helpful Questions to Ask Yourself
Is the market overbought?
Am I chasing the market?
Did I wait for a pullback?
Should I bail out or wait to see what happens, since the market is reaching an oversold level?
Am I using the indicator properly?
Am I trading with the major trend?