Chapter 12, Part IV. Stochastic. Part 4

Discussion in 'Complete Trading Education- Forex Military School' started by Sive Morten, Dec 20, 2013.

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1. Sive Morten Special Consultant to the FPA

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Estimation Oversold/Overbought conditions

Many traders use Stochastic for that purpose also, but very often use it wrong. It is recognized that the market is overbought when Stochastic exceeds the 75 level and oversold, when it falls below the 25 level. But this is not how G. Lane, Stochastic creator, teaches us. If you still are not sure that this is it – take a look at the rectangles again, on Chart #1. See – stochastic stands above 75 and below 25 for a long time, but the market is going and going further. Hence – this is a wrong approach to estimation overbought and oversold condition of the market.

Pipruit: But why is it happening in that way?​

Commander in Pips: This is because of how Stochastic is scaled. We already know, that stochastic couldn’t move higher than 100 and lower than 0. Hence, if market shows some nice thrust and Stochastic reaches, say 85, then in this case the Stochastic has only 0.15 of free space to move up for all possible market upmove continuation. This has forced stochastic to stay around the 80 area, despite o how far the market will move. Particularly this you can see in the rectangles. It means that application of Stochastic for overbought and oversold estimation is limited – you will be “killed”, if have entered the market due to these signals.

Personally I do not use Stochastic for overbought/oversold estimation, generally due to its normalization. I think that an indicator should be not normalized for this purpose.

Pipruit: Thanks, I see.​

Commander in Pips: Another negative moment of using Stochastic is that you rarely will able to enter the market on a retracement due to its signal. For instance, the market shows an excellent move up, Stochastic stands above 75 for some time. Now the market is turning to retracement and shows a gradual move down. For instance, you intend to use this pullback to enter Long. But for that purpose, you need a Stochastic “Buy” signals according to our rule – crossing lines below 25 and moving outside. And I tell you, that you hardly could get such a signal during a solid up trend. The same for a downtrend. So, here are my thoughts:

1. Applying strict rules of signal creating could lead to acceptable results. But if the move will be significant, you have the risk not to get signal from Stochastic during pullback, that you intend to use for entering the market;

2. Better is to use Stochastic on intraday charts for trend estimation;

3. Stochastic is hardly suitable for Oversold/Overbought estimation, because:

- Many significant moves happen, when stochastic already stands above 75 or below 25 – just take a look at Chart #1 again;

- Stochastic is scaled (normalized) in 0-100 range, hence it does not have enough room to clearly show oversold and overbought condition.

You can try Stochastic for both purposes, may be you will be able to tune Stochastic, so that it will become your favorite trading tool. And our discussion today will help you to avoid possible confusing moments.
Later we will take a look at MACD/Stochastic combination for trend estimation.

P.S. This lesson was written by Sive Morten, who has been working for a large European Bank since April of 2000, and is currently a supervisor of the bank's risk assessment department. Sive's knowledge of forex market and banking industry is vast and quite complete. If you have any specific questions about forex, banking industry, or any other financial instruments, please post them on the next page and Sive should answer soon.

Note: FPA ranks are earned in the battles against scam, not in the classroom.

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