Momentum. If you look at the way I trade, you will find momentum is the key difference in my trading style and the chart traders or the pure oscillator traders, and the stochastic indicator is an accurate momentum indicator. I would not put the stochastic indicator in a class of oscillator that is sufficient to day trade as a single indicator system. It is a wonderful indicator to have in your day trading arsenal to confirm trades and glean information, which is exactly how I use the indicator.
In a pure sense, the stochastic indicator is a classic momentum indicator. The mathematical formula for the Stochastic indicator is as follows:
%K = 100[(C - L14)/(H14 - L14)]
L14 = the low of the 14 previous trading sessions
%D = 3-period moving average of %K
C = the most recent closing price
H14 = the highest price traded during the same 14-day period.
Even a cursory review of the formula leads us to the conclusion that the stochastic indicator is comparing the current price and the high and lows, the range, throughout a 14 day period. It should be noted that a day trader can set the length of time for the indicator, and a setting of 14 periods is very common. I have experimented with several different numbers, with mixed success. The charting period I trade in is 3 minutes on the ES emini, but it could be hours, day or months. As an emini scalper, I trade the shortest term trend in the market, but this indicator is often used for longer term trading. It is a versatile trading indicator and can be adapted for a several different trading periods, if necessary.
Most traders will recognize the stochastic indicator configuration on the chart, as it uses the traditional crossing line format. When the two lines cross (called %D and %K) a trade is indicated. Long crosses and short crosses are determined by which line is topping the oscillator. If the short line, usually a red line on most charts, crosses thru the long lines, which is usually blue, it indicates a short trade. The exact opposite is true of long trades, when the blue line crosses through the red line, the short trade line, a long trade is indicated. Like nearly every non-linear oscillator, the stochastic indicator will whipshaw you to tears if you are trading it alone, in and out of day trades, when the market is in a consolidating mode, and I strongly warn against trading it as a single indicator.
In some of the previous articles I have written, I point out the notion of divergence as the stuff of gold. If the stochastic indicator is moving in the opposite direction of the market price action, you know the trend is losing some steam, at least temporarily. Obviously, if you are in a trade and the stochastic indicator diverges from the direction your trade, you would seriously consider exiting the trade or, at the very least, be prepared to exit the trade.
The stochastic indicator was developed in the mid-1950s by Dr. George Lane and it remains a popular indicator to this day. The indicator comes in 3 flavors, called the fast, slow, or full. I prefer the slow stochastic, as I find it does not bump me around as much. But the fast and full stochastic indicators have applications for day trading, and traders have flocked to all three versions of the stochastic in droves.
What makes the stochastic indicator so popular?
The stochastic indicator is reasonably reliable, and easy to use. I think the indicator imparts a wealth of information about momentum in the chart, up or down, and traders are naturally drawn to such an easy indicator to read. The trade entries are easy to spot, and a quick glance at the chart can give you a snapshot of what is really occurring in the market with the emini contract you are examining. The stochastic indicator is easy to use, understand, and implement into even the newest traders mind. That being said, it is still difficult to qualify the stochastic indicator as a primary trading tool. It tends to whip you in and our of trades in consolidating markets. I would recommend putting the stochastic indicator on your chart and see if it behaves in a way that is favorable for your trading style. You might like it.