Stochastic are the leading technical indicators. They are widely used for swing trading along with other indicators like RSI and MACD. Learn about the best stochastic settings for swing trading and day trading.
Swing trading is short term trading lasting for few days of time frame. A swingtrader tries to catch the small or big swings in share prices to earn the profits. Technical indicators are used to get the entry or exit signals for a swing trade.
The best indicators for swing trading are the relative strength index (RSI), stochastics and the moving average convergence divergence (MACD). It is always advised to use more than one indicators to get a signal and not rely on single indicator.
There are lots of technical indicators available in technical analysis. Traders use them to strengthen their trading plan. The disadvantage with some of them is that they give buy or sell signal when the price move in the security has already occurred. So the chance to earn big profit may already have gone. They are the lagging indicators.
Uniqueness of Stochastic lies in the fact that it is a leading indicator. It means it gives the signal much before the move in prices occurs. Moreover, it gives more accurate entry or exit points than other lagging indicators. It generates signal before the move occurs in the stock prices. The traders get early signals for a trade. This enables the traders to maximize their profits.
Stochastic Oscillator is a momentum indicator. It has an important role in technical analysis for a trader. Their significance lies in predicting the appropriate entry and exit prices in a trade.
Stochastics was developed by George Lane. Stochastics give a relatively reliable signals for trading. They are really best if you combine them with another one or two technical indicators.
Different trading software use different settings for stochastics. They are usually set as default in these software. I will be discussing here the settings for stochastics which worked best for me for swing trades.
Before we go into the settings, let’s have some idea about stochastics ; what are stochastics and what are the important things you should know while using stochastics oscillator.
Stochastic give the most recent closing price of a security in relation to the average highs and lows made by the security in a particular time frame.
It consists of two lines ; %K and %D. Crossing of %K line above or below the %D line generates the buy and sell signals.
In most of the trading software , %D line represents 3 time periods while %K line is for 5 time periods.
Calculation:- Now a days there is no need to manually calculate the stochastic. All the modern day charting software can draw it directly on the security chart. Thus, it makes it quite easy to apply it.
The formula to calculate stochastic is as below :-
%K = [Closing-Low/High-Low price in previous 5 time periods] X100
%D = [High/Low of previous 3 time periods] X100
How to Use Stochastic Oscillators
Stochastic for a security keep fluctuating between 0 – 100 on the technical chart.
It represents if the security is overbought or oversold. Values above 80 represent overbought. Values below 20 represent oversold security and therefore possible reversal in the ongoing trend.
While using stochastic oscillator, we have to look for %K line crossover the %D line.
When %K line crosses below 80 level after crossing above it and also crosses %D line in the process, it is a signal to go Short for the traders.
Similarly, when the %K line crosses above 20 level after crossing below this level and also crosses %D line, it is a signal to go Long (see yellow arrows in the figure and corresponding stock moves in the chart above that).
It needs to be remembered that overbought security may not start retracing back immediately. It has the probability of remaining in overbought territory for extended periods of time. Similarly true is for oversold conditions.
So, it becomes imperative to trade in the direction of longer term trend of the market. In bull markets, you can look for oversold security to go long. On the other side, look to go short in overbought situations in a longer bearish trend.
Applying Stochastic as a single indicator to decide for a trade can not be 100% accurate. It is better if we apply it along with other indicators like relative strength index (RSI) or MACD or moving average convergence divergence indicator.
Stochastic can be more useful if applied along with support and resistance for that stock or security.
Types of Stochastic Oscillators
Stochastic are of two types –
Fast stochastic are more sensitive to price moves. Hence probability of errors can be there in very short-term trading.
Slow stochastic being slow are more useful as being less sensitive. The margin of error is considerably reduced.
So slow stochastic are more popular among the traders when looking to apply stochastic in their trading plan.
Divergences In Stochastics Oscillator
In more advanced analysis, traders can look for positive and negative divergences. The divergences indicates the potential trend which is about to start.
Positive divergence is when the stock price is making new low while the stochastic is making highs after crossing 20 level. It indicates the bullish trend is about to start in the stock. So, the traders need to be positioned on the long side.
See in the above daily candlestick chart, the stock price is in downtrend and moving lower. However, the stochastics are not moving lower but making higher lows. Thus, the price action is in divergence to the stochastics. This tells us that the selling pressure is getting exhausted and stock price may move higher. Keeping the swing low as a stop loss, traders may consider buying the stock. See, how the stocks started moving higher after the positive divergence.
Negative divergence is when the stock is making new highs while the stochastic is making lows after crossing the 80 level. So, traders need to be cautioned or should decide to go short as the stock may start falling.
In this chart with negative divergence, the stock was making higher highs while the stochastics was making lower highs continuously. This set up indicates us that the up trend in stock price is near exhaustion. It is time to exit our long positions and look for short selling the stock.
Best Stochastic Settings For Swing Trading
Swing trading is for a very short term. It may extend from 1 day to few days duration.
Stochastic oscillators can be an ideal indicator to get a trading signal for a swing trade. It is important to mention here that you do not rely solely on the stochastics.
Along with a stochastic crossover, you also take a look at the daily candlesticks. Look for any bullish or bearish candlestick pattern.
The above image is an example for TCS stock. The slow stochastic was above 80 or 93 to be more precise when it gave bearish crossover. So the sell signal was generated.
And also if you look the chart carefully, there was a ‘Top’ formation before which the stock tumbled to lower prices.
After the formation of 2 red candles on February 8 and 12, I shorted the stock on February 13. Although the stock saw a spike towards previous highs but it started falling after that.
I bought Put Option on that day. The profits were quadrupled after 3 days. The Option price which I bought at a price of 32 was trading at 141 after 2 days.
That is the power of stochastic crossover to help you make money if it is spotted and executed timely.
The stochastic settings which can be best for swing trading :
%K Periods – 9
%K Slowing – 3
%D Periods – 9
Moving Average – Simple
Stochastic Settings For Day Trading
You can use stochastic settings for day trading also. Same rules apply for day trading also, just like we discussed for swing trading.
For intraday trading, you can use technical charts for various time periods ; Hourly, 30 Minutes, 15 Minutes, 5 minutes or 3 Minutes.
To reduce the noise and avoid false signals, I personally prefer hourly charts for intraday trading.
Use candlestick charts for hourly charts. Look for bullish or bearish pattern formation as we saw the Top formation in previous example.
Stochastic settings for Day Trading :
%K Period – 20
%K Slow – 3
%D Period – 3
These settings work best for me. You can also try these settings. they should work best for you also.