Make Money with Stochastic Hot Pursuit (In 15 Minutes)

Since the stochastic indicator gives many invalid signals, it is usually combined with another oscillator indicator to filter out these invalid signals. First, let’s get into what stochastic defines and what different ranges mean.

The stochastic formula states that first, you must choose a length for your stochastic indicator. This length is the number of candlesticks the indicator considers in the chosen time frame.

Usually, lengths of 5, 9, and 14 are preferable. George Lane personally suggested the 14-candle length. Based on the stochastic formula, you must subtract the lowest price of the chosen length from the last candle closing price.

After that, subtract the length of the lowest price from the highest. Then, divide the prior number by the latter and multiply it by 100. voila, that’s your stochastic percentage (K% for the police car). To simplify the equations, use a single candle as the whole length.

The other variable is the D% or the signal line (the thug’s getaway car), which by default is a Simple Moving Average (SMA length=3) applied on the K% variable. Additionally, the Exponential Moving Average (EMA length=3) can also be used.

Similar to the RSI indicator, the stochastic indicator forms three major areas: the overbought area above 80% (bad neighborhoods), the oversold area below 20% (downtown), and the neutral zone in the between. Looking at the real-time price charts and stochastic graphs, you see that the stochastic graph (police car) chases the moving average graph (thug’s car), mostly in the neutral zone.

Occasionally, you can see the chase dragging into the downtown or bad neighborhoods, which results in one car outmaneuvering the other. In this metaphor, the price chart is the citizens’ trust in the police. When the cops outperform the thugs, the trust (the price) increases; otherwise, it decreases.

As for what these two city areas mean for the price, when both graphs are moving deep in the downtown (OS), it means the price has high downward momentum, and when they are deep in the bad neighborhoods (OB), the price has upward momentum.

As mentioned in the RSI article, entering the overbought or oversold areas does not provide any signals for traders — but depending on the cop’s and thugs’ performance, leaving it does.

The moment both cars change direction and instead of going deep inside the OB or OS ranges, they start moving toward the exits, the price momentum direction also changes. The car’s direction shift mostly hints at a potential price direction shift.

The breakout of 20 or 80% lines toward the opposite direction is the first signal of the shift. If the breakout keeps its momentum and breaks the 50% line as well, a shift in price direction is almost guaranteed. In the next section, you will learn how buy/sell signals form and how to use valid signals to open money-printing positions.

You sometimes might also see divergences form in the charts. This usually hints at potential market reversals. Let’s see how to identify these signals and use them in our trades.

When our hot pursuit drags on downtown, where there are more cops stationed, it is easier for the cops (K%) to outmatch the thugs (D%). If the police car (K%) surpasses the thugs (D%) as they leave downtown, people’s trust (the price) increases.

That is why the blue graph (K%) crossing the red (D%) upward in the OS area is bullish. If the blue graph (K%) stays higher than the red (D%) as they leave the OS area, it counts as a “buy” signal.

This scenario can also happen the other way around. With the chase in bad neighborhoods, more thugs might cause distractions for the police so that the red graph (D%) can cross the blue (K%) one downward. With the thugs outmatching the cops, trust (the price) drops.

A valid sell signal forms after the downward crossing of the blue graph by the red as they leave the OB area. Bear in mind that the deeper the chase drags into the oversold or overbought and the longer they stay in these areas, the more valid the signals become.

You can also detect divergences when analyzing the price chart and the stochastic graph. Depending on the formations, the divergences can both be bullish and bearish signs.

If you see two ascending peaks form in the price chart while two descending peaks appear on the stochastic graphs, it is called a Regular Divergence (RD-) divergence, which hints at a price reversal downward. The inverted version of this is called a Regular Divergence (RD+), signaling an upward reversal.

The divergence story doesn’t end here; there are two different types of divergences, regular and Hidden Divergence (HD). I don’t want to get too deep into divergences here, so we’ll cover that topic in a future article.

In the trading world, stochastic and RSI go together like peanut butter and jelly. Since RSI signals and stochastic signals usually overlap, many might ask the question: why should I use stochastic instead of RSI?

Stochastic provides much more signals than RSI, with a much higher chance of failure. This sounds logical only when you are in a strong price trend and RSI doesn’t provide enough signals. Now that you know how you get to buy and sell signals in the chase, you must plan a strategy; as Morris Chang says, laction without strategy is aimless.” Let us talk about strategy.

Follow the strategy properly, and you’ll enjoy profits. In this section, I’ll share an experience of mine in which I made $11000 using the stochastic indicator.

Now that you know how citizens’ trust goes up or down based on the cops’ performance compared to thugs, you need a strategy to make to most of the provided buy/sell signals.

The popular trading strategy is traders’ preferable strategy when they want to use the stochastic indicator. This strategy combines the multi-time frame, RSI indicator, and moving average with the stochastic graphs. First, you must look at a higher time frame (trend time frame) to find the market’s bigger trend using the Simple Moving Average (SMA 60).

Then, you can add the RSI indicator to the trend timeframe to find how strong the trend is. The trend time frame must be 4 to 6 times longer than the trading time frame. This means if you choose “1 day” for the trend time frame, for the trading time frame, you would use the 4-hour option.

After finding the market direction, you switch to the trading time frame, add the default stochastic graphs, and consider signals in the direction of the higher trend as valid entries.

Although this strategy is effective, there are endless combinations and strategies that you can try. My advice is to try different combinations (backtest) and then customize your own trading strategy using other strategies’ key takeaways.

Now that we know how it works, I think it is time to share a real-world example — the story of how I made eleven thousand dollars with a single trade using the stochastic indicator.

Trade Experience 

At first glance, you might not recognize the indicator that I have used. The Stochastic of Relative Strength Index (StochRSI) is not much different from good old stochastic; the only difference lies in the stochastic calculations done on the RSI instead of the price. (I will discuss StochRSI in more detail in the upcoming section.)

I was watching the Bitcoin chart in a 15-minute time frame (BTC/USDT) when I saw the downward price hit a support zone. While it was forming a bottom, I added two moving averages: one Exponential Moving average (EMA 60 blue), and the other a Simple Moving Average (SMA 60 red).

It was a heartwarming pattern was in the making, a classic reversal, the three rising valleys pattern. I couldn’t confirm the pattern at the moment; however, a beautiful marubozu candle broke out at the second peak’s price, validating the pattern.

With the StochRSI added, I received a buy signal immediately after. At the same time, the EMA 60 line crossed the SMA 60 upward, providing another buy signal. I opened my long position at $17280. Safety first: I fastened my seatbelt and placed my stop loss below the green breakout candle at $17180 (below the third valley).

Based on what I mentioned in my three rising valleys article, I set my first 50% take profit price at $17350 and then waited for the SMA 60 to cross the EMA 60 line downwards for my second profit half. At $17390, the blue EMA crossed the red SMA downward and I closed the position with a total of $11000 in profits. Not bad!

Now that my $11000 of profits has boosted our energy, it is time to learn more about what scientists found while researching the stochastic indicator and how we can use it to increase trades’ win rates.

The story of the StochRSI (Stochastic of Relative Strength Index) began in 1994 when two clever analysts combined the RSI indicator with Stochastic. Tushar Chande and Stanley Kroll called their Frankenstein-indicator the StochRSI. Don’t let the name scare you; it is not that complicated. It’s our familiar stochastic indicator, but instead of the price, its formula was applied to the RSI indicator.

After testing the StochRSI in the market, they found that it is much more reliable and successful than the normal Stochastic indicator. (As a side note, I’d better mention that you must backtest different lengths for each asset to find the sweet spot you are comfortable trading with.)

Like the normal stochastic oscillator, the stochastic of relative strength index is on a scale of 0 to 100%, mostly ranging between the 20 to 80% range. Also, its frequency is less than the default stochastic.

To use it for signals, all I mentioned about the cops and thugs chasing applies here. Everything about the signal conditions and validations are the same; the only difference goes back to calculation (RSI instead of price).

What is the definition of a Stochastic?

The Stochastic indicator is an oscillator from a scale of 0 to 100 that shows market momentum. When added, you can usually find it below the price chart. It consists of two graphs: one is stochastic, and the other is usually its moving average.

What are Stochastic variables?

The stochastic indicator consists of two variables, K% and D%. K% is the normal stochastic graph and D% is the stochastic moving average (MA). These two are demonstrated as two graphs on a scale of 0 to 100%.

How to calculate Stochastic?

The stochastic formula states that to calculate the stochastic you first must choose a length for your stochastic. Then, subtract the length of the lowest price from the candle’s closing price. After that, subtract the lowest length price from the highest. Finally, divide the prior calculated number by the latter, multiplied by 100.

How can I use a Stochastic oscillator?

The stochastic indicator is a ranging oscillator that provides traders with buy/sell signals. It consists of two graphs. One is the normal stochastic (K%), and the other is its moving average (D%). When the K% crosses the D% graph upward and both break out the 20% line, it’s a “buy” signal. The opposite of this scenario, happening on the 80% line, is a “sell” signal.

What is a StochRSI?

The Stochastic of Relative Strength Index (StochRSI) is not much different from the normal Stochastic. The only difference lies in the calculations. In the StochRSI, the formula applies to the RSI instead of the price. It usually provides more reliable signals, with a higher win rate than normal stochastic.

Conclusion

Using indicators properly separates amateur traders from professionals. In this article, you learned many invaluable lessons about the stochastic indicator. From how it is calculated to how you are supposed to work with it, you learned it all.

Make sure you review and take notes of what you learned and practice as much as you possibly can. Although learning about professional traders’ strategies is beneficial, your primary focus has to be customizing your own trading strategies.

Make sure after practicing the strategies that you compare the results. If you master the stochastic indicator properly, huge sums of dollars await you in the market. I thank you for following me through this journey and I would love to see you again in the next one.