Tuesday, January 6, 2009

Stock Technical Indicator: Stochastic Indicator

Stochastic indicator is another very popular technical analysis indicator used by stock traders. You might already read about Moving Average Convergence Divergence (MACD) in my previous post, then this post will be another great improvement to MACD technical analysis. By using the combination of MACD and Stochastic, you can almost always predict the price movement of a stock on the next day.

Stochastic is a good indicator to show the momentum of a stock. The larger the momentum, the higher the probability that a stock will be moving up the next day or next few days.

I am not going to talk about the history of stochastic. It is a long story. In this post, I am going to share some of my idea to make use of stochastic indicator to help you enter and exit a trade.

Basically, stochastic is divided into several sections:

Look at the picture above. Stochastic is divided into 2 main zones which are Overbuy zone and oversell zone.

Descriptions of Zones:

Overbuy: This zone is the area above 80% line.
Oversell: This zone is the area below 20% line.
Middle Zone: This is the zone in the middle which is 50%.

For me, middle zone is very important. Now, please follow very carefully. If you have a note or paper and pen, you can write down some of the important points I am going to mention below. These points below is my research and analysis using stochastic to predict price movement, so I hope it will be useful for you too. I setup some rules for myself as below:

Important Points when using Stochastic:

1. Look for a stock that has the stochastic dotted line below the 20% line. This means that very few people are holding the stock at the moment. Thus, demand for this stock is low and so the price is low too.

2. Wait for the stochastic dotted line to go up and touch 20% line. When the dotted line start to cross 20% line, it means that Buyers is coming back. More people are coming for the stock. When demand is going up, the price will go up too.

3. Prepare to buy the following day. You need to check the price for the next day. Watch the price movement.Normally, I will place an order at the close price of previous day so that I can get the stock the next day. 4. Exit when the dotted line crosses 50% line. I MUST exit (sell) the trade when the dotted line crosses the 50% and reach around 60% or 70%. Stochastic tells us that a lot of people are now buying and holding the stock and it will become overbuy soon.

5. Don't Be Greedy. It is very important for you to trust the indicator. Do not be greedy. When the indicator tells you to sell then sell.

Now, you have learn about stochastic. You can read the following example to look at stochastic in action.

Simple Example: The picture below is taken from ChartNexus, I am using ChartNexus Free Version and I found that it is very useful and it is very good. So, please look at the price movement of AMMB in the picture below:

From the picture, you can see that AMMB is always having a small uptrend (price moving up) when the stochastic is moving up. So, that will be the chance for us to buy in AMMB and then sell it at higher price.

As you can see, stochastic always tell us the entry point for AMMB stock. So, please read my 5 Rules for Stochastic again and compare with the picture of AMMB stock price movement.

You will see that:
1. Whenever the dotted line crosses 20% line, it is showing a change in trend. Price is moving upward the following days.
2. Whenever the dotted line crosses 50%, the price is not going to sustain. It will soon fall down.
3. When the dotted line crosses 80% (Overbuy), you know that the price of stock will come down someday. So, wait for next turn to make money.

**Note: Remember that you should not enter a trade by using Stochastic alone. You need to use some other indicators to help you confirm the up trend before you decide to trade.

Some other indicators that you will need to use for best prediction are ADX, RSI, MACD and so on.


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