I trust you are trading well and you all had a profitable month. Today I will discuss the best use of Stochastic as an overbought and oversold indicator and the psychological reasons why traders fail to utilize this information to profit from the Forex market.
What is Stochastic?
The word Stochastic comes from mid-17th century: from Greek stokhastikos, from stokhazesthai ‘aim at, guess’, from stokhos ‘aim’. It is defined as ‘having a random probability distribution or pattern that may be analyzed statistically but may not be predicted precisely.’ George Lane invented this indicator in the late 1950’s.
(2006).(2 ed.). . p. 1. A stochastic process is a random process evolving with time. More precisely, a stochastic process is a collection of random variables indexed by time.
In Forex Market, Stochastic is used as a momentum indicator. It is an oscillator that measures the rate of change of prices. Stochastic oscillator signals a turn in the market ahead of the price because the momentum changes before the price. So, in essence, the stochastic is indicating a change of market sentiment from Buyers to Sellers or vice-versa. Interestingly put by several traders, the rate of change of an object will show decreasing momentum until the object actually Changes ‘direction’. Stochastic generally do well in a non-trending market than in a trending market. But as you can see in the example below the Oscillator has made the trending market trader money too by signaling a change in momentum. If the market is in a highly trending mode, agreeably there can be some false signals generated. Therefore, most traders use this signal as a confirmation signal after considering other variable not as a leading entry signal.
Let us consider the examples in the following pairs where one pair is Trending, and the other is Ranging. The proper utilization of the stochastic signal is helping the trader make money with an entry signal as well as a trader who is already in an open position. This trader can avail the opportunity to exit the trade with profit. Therefore, in my opinion, the stochastic is also helpful to make a decision to exit a trade and lock in the profits in a trending market.
AUDCHF – Ranging in Daily Chart – Interbank Radar
The most popular use of the Stochastic indicator is in the overbought and oversold range indicating that if a pair is overbought it will eventually have the sellers come in and if it is oversold it will have buyers dominating the timeframe shortly. The market will not move in any one particular direction for a very long time. It will Cycle, sooner or later will run out of steam – it will run out of buyers in an upward move and sellers in a bearish move. If the market moves up sharply without a retracement, then it is shown as overbought in Stochastic and if it drops down sharply without a retracement, then it is in an oversold area. This concept is also applicable to predict a short-term price movement against the trend. The stochastic has commented to fall apart as a reliable indicator in a heavily trending market. But in the current market situation, it is doing well for traders as the most market is sitting in a middle trend and a few pairs range for longer periods.
If you are a trader who likes to buy dips and sell rallies and is willing to take a loss when the market starts trending again, then this would be a good indicator for you. Hence you get to trade in both Phase 1 and Phase 2 if you choose. This pull back can be somewhat detected by your Stochastic Oscillator.
The Stochastic measures the price action of last X number of bars in the specific Time frame that you have selected (in the above case it is a 4-hour chart) with a specific mathematical formula to indicate momentum. You don’t need to know this complex mathematical calculation as your software will do it for you.
- If the Price action is making higher high and the stochastic is making a lower high you are looking for a sell opportunity or locking in your profit from a buy order as the momentum is running out of steam.
- If the Price action is making lower lows and the stochastic is making higher lows than you are looking for a buy opportunity or locking in your profit in a sell open position.
AUDCHF – Ranging in Daily Chart – Interbank Radar
In this AUDCHF chart, you can see clearly the performance of the indicator for both open position and a confirmation signal to enter or not enter a trade. Just because you have a flashing signal on your strategy doesn’t automatically make it a winning trade. The signal is generated by the algorithm programmed to detect the price action divergence with stochastic. As soon as there is a divergence you will get the signal. This is where your oversold and overbought area will help you choosing a higher quality trade.
How do traders mess it up? So if this is that obvious, why do traders mess it up? This has been a long-lingering question asked over the years. The answer is obvious it is because of the psychological pre-programming about wealth consciousness. The excessive greed also stops these traders from following their own strategies. Combine this with old inconsistent behavior patterns you have a highly evolved trader losing money and a Rookie newbie making money by following simple rules. This is all about creating discipline and keeping a check on your risk profile and Trade management. In either case, the Rookie trader also knows that there is no escape from doing some chart study and re-evaluating a trade before pulling the trigger!
You can start implementing change now by taking some simple steps.
Step 1: Write out your precise plan for using this stochastic indicator. Step 2: Study the pattern in a minimum of 50 trades. You can use this as an exercise and pick a few pairs and go back test (meaning look at the performance on a trending pair and on a range pair) Step 3: Write out how you can make the most of this indicator. Be precise. Step 4: Set up an anchor for yourself to look for at least the oversold overbought concept in all your Daily and H4 timeframes. Step 5: In your goals set a reward for a successful week because of using this indicator and a negative consequence for not following your own rules. Step 6: Make it a part of your identity that you follow your trading rule and associate it with following the traffic signals during the long weekend (when there are double demerit points!). This will instill in your mind an association of reward for following rules and punishment (like losing money as in fines) for breaking the signal rules. Step 7: If there is a challenge in following the rules than make a drill for yourself and read it loudly as your daily affirmation. For example:
- I am a disciplined person
- When I take consistent action, I get consistent results
- I love following trading rules
- I enjoy making money from Trading
- It is easy to make money from Trading
- I am in the top 3% of the world class traders
- Every day and in every way, I am getting better as a trader
You already have figured out that an undisciplined trader is a poor trader and a disciplined trader reaps the benefits of fun and luxury. Write out in your goals that you are a disciplined trader who is a pip collector and who donates very little to the market and much more to his/her family, friends, community and the world of possibilities.
I would love to hear from your success utilizing the psychological techniques to follow this strategy most effectively. Til next time I wish you disciplined trading.
Enjoy a prosperous month,
Psychology of Trading Specialist
Acknowledgment to the Books & Authors consulted: ‘Trading in the zone’ by Mark Douglas & ‘How to make a living Trading Foreign Exchange’ by Courtney Smith. ‘Unlimited Power’ by Anthony Robbins & NLP Demystified – A pragmatic guide to communication and change by Byron Lewis.
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