Using Stochastics to Ferret Out Trades

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

NEW YORK ( The FRED Report) -- There have been some interesting discussions on the financial news shows recently on how to use "stochastics" so we thought an article on how we use this indicator at The FRED Report would be useful to readers.

First, let's define these indicators. Stochastics are an indicator market analysts use to measure overbought and oversold conditions in traded instruments. The indicator shows where the current market is closing within the trading range over the last "X" periods of time. We like to display this indicator in the pane on the bottom of our charts.

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Moving averages are depicted on our price charts above stochastics, and are my favorite determinant of trend. We show a long-term chart below, and ask readers if your own investment performance is as good as that of a simple 5/20-monthly crossover strategy.

Most traders use stochastics to buy and sell without reference to trend, buying when the stochastic moves below and above 20, and then selling, and possibly selling short, when the stochastic moves above and then below, 80. While this is an acceptable way to use the indicator and can help traders make money on a short-term basis, there are ways to use the indicator in relation to the trend of a market. This enables a trend-following trader to enter the market in advance of a trend change, and then add positions on confirmation of that trend.

Obviously, this is riskier than simply waiting for a trend-following signal line the moving average cross depicts above, but it can pay dividends. We will show some examples below -- but first let's look at some background information. Also, please note that this is subjective and not a mathematically quantifiable methodology.

We advocate using a combination of daily and weekly charts, with daily charts used to refine our view of the trend, and daily charts used to enter in the direction of the weekly trend. We use the 5- and 20-week moving averages, as well as price patterns, to determine the trend on the weekly chart. For the stochastics, a buy indicator moves below, and then back above 20, and a selling indication moves above, and then below, 80.

On the chart above, readers can see two examples of this strategy, one short from late July through August, and another minor signal into the October low. The second main indication is a buy on the stochastic in early October, followed by a cross of the moving averages to add another position. The moving averages still have the trader long this market. We show another example below.

GLD, above, also had a couple of successful trades using this method. Note the buying indication in late July, and the selling indication in September. Notice how, on these charts, stochastics gave buying indications in advance of the moving average crossovers, which then confirmed the stochastic moves, and allowed you to ride the trend.

To conclude, combining stochastics and moving averages can ferret out some interesting and profitable moves in the markets. Sometimes the best part of the move occurs when the stochastic becomes overbought or oversold, without giving an opposite indication. We use this indicator to get the jump on a moving average signal, and then use the moving averages to add more to, and then close out a trade.

Fred Meissner is founder and publisher of The Fred Report. Fred is a CMT and past President of the Market Technicians Association (MTA). He recently left Merrill Lynch's Market Analysis Department and Sector Strategy Department to form The Fred Report.�A detailed bio is here: Fred Meissner.

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