George Lane is known as the “Father of Stochastics.”
Stochastics is a momentum indicator meant to give traders a feel for when the market might be getting ready to change direction. A Stochastic reading of 80 indicates a market that is overbought while a reading of 20 indicates a market that is oversold. This Indicator is the foundation to the HPS methodology. Out of the 5 other important indicators, the stochastics is the one that I require in every High Probability Setup. This could be in any time frame depending on the duration of the trade.
There was a great interview with George Lane 10 years ago by By Allen Sykora and I think Lane does a great job describing how stochastics work in the market here’s an excerpt below
“Stochastics is a momentum oscillator,” said Lane. “It doesn’t follow price, it doesn’t follow volume or anything like that. It follows the speed or the momentum of price. As a rule, the momentum changes direction before price.” He made a comparison to a rocket speeding away from the Earth. Before the rocket can turn and head back to the ground again, it must first start to slow down. “The slowdown of momentum happens before the change of direction,” continued Lane. “It’s a leading indicator of the change in direction. That’s what Stochastics does. It predicts the direction of movement.
I love that quote “It’s a leading indicator to the change of direction”
Just the simple understanding of momentum and the example of the rocket. You can see how stochastics can give you that added edge to finding a good entry point. I use stochastics as the foundation to the High Probability Setups (HPS) method. By combining basic trends, support, patterns and the stochastics, you really do find the Highest Probability area where a stock will turn
Stochastics work on every time-frame and every trading vehicle. Futures, Stocks, etc.
Lagging indicators react to price, Leading indicators predict price.
Great trades are usually planned out. HPS is proactive, not reactive.
For myself, Stochastics are not just and overbought oversold indicator, there are many aspects to this oscillator. I will explain each of them here.
My Rules:
I do not use stochastics alone it works best when combined with one or more of the other HPS indicators. I do require it in any potential HPS.
I use slow or full stochastics vs fast. There are three versions of the Stochastic Oscillator you will run across. The Fast Stochastic Oscillator is based on George Lane’s original formulas for %K and %D. %K in the fast version that appears rather choppy. %D is the 3-day SMA of %K. In fact, Lane used %D to generate buy or sell signals based on bullish and bearish divergences. Lane asserts that a %D divergence is the “only signal which will cause you to buy or sell.” Because %D in the Fast Stochastic Oscillator is used for signals, the Slow Stochastic Oscillator was introduced to reflect this emphasis. The Slow Stochastic Oscillator smooths %K with a 3-day SMA, which is exactly what %D is in the Fast Stochastic Oscillator. Notice that %K in the Slow Stochastic Oscillator equals %D in the Fast Stochastic Oscillator
Below you can see all 3 types and how the Fast %D equals Slow %K.
Fast Stochastic Oscillator: Fast %K = %K basic calculation Fast %D = 3-period SMA of Fast %K Slow Stochastic Oscillator:
Slow %K = Fast %K smoothed with 3-period SMA Slow %D = 3-period SMA of Slow %K
Full Stochastic Oscillator: The Full Stochastic Oscillator is a fully customizable version of the Slow Stochastic Oscillator. Users can set the look-back period, the number of periods to slow %K and the number of periods for the %D moving average. The default parameters were used in these examples: Fast Stochastic Oscillator (14,3), Slow Stochastic Oscillator (14,3) and Full Stochastic Oscillator (14,3,3). Full %K = Fast %K smoothed with X-period SMA Full %D = X-period SMA of Full %K
The default setting for the Stochastic Oscillator is 14 periods, which can be days, weeks, months or an intraday timeframe. A 14-period %K would use the most recent close, the highest high over the last 14 periods and the lowest low over the last 14 periods. %D is a 3-day simple moving average of %K. This line is plotted alongside %K to act as a signal or trigger line. Because the Oscillator is range bound (0-100) it will be susceptible to times when the market will be in extreme overbought or oversold levels and the stochastic indicator will be pinned at the extreme level of the current price direction. This is called embedded stochastics and the signals become less effective. It is a signal you have to feel out a bit. I want to see the embedded signal usually below 10 or above 90. Embedded Stochastics: can be defined as 3 periods (Time Frame) in an extreme level with sideways flat movement measured on any time frames but works best on 60 min and daily chart.
Very important TIP: I use the stochastics basically like this in a nutshell. In an up trending market, I will use the stochastics to time quality stocks in low risk pull back zone, and use it the opposite with down trending markets. Short stocks that have pulled back (bounced) and have gotten overbought. The reason is if you try to short an overbought level in the markets because you have a high stochastic reading near 100 but the market is in a confirmed uptrend. You will fall prey to the false signal because you are shorting a strong market and the stochastics will be embedded. Whereas you will be in a great position for a continued uptrend when you get the short term oversold reading to buy into.
The most popular way that traders look at stochastics is a simple oversold and overbought reading. I would guess most people look at stochastics in this way. That’s actually good the signal is a reliable one., and when back tested on different stocks or another trading vehicle you will see pretty consistent results but this is looking at the chart like a painting. I can see the shape and form and the overall picture is nice. But I am missing a lot of the details. You will see on the chart below how the stochastics do a good job of forecasting a turn in the markets but the time frame for the moves are larger and there is a lot of chop before any move is confirmed.
I always have this indicator on my screen and it is the main criteria for a trade setup but it has to be combined with at least 2 other indicators lining up the same time. I consider the stochastics the wing and I want it in my sail I do not want to go against it if I can. This next setup is called The Coiled Stochastic:
The Coiled pattern, when applied to the stock market, represents a tightening of volatility and of a compression on price action that in theory has become “Coiled” and that in itself means the current tension will release itself in a larger than average move based on the last 7-10 days.
I have coined the term “coiled stochastics” to mean basically the same thing only related to momentum. It is also very easy to identify and is one of my favorite signals to trade off of. The cooling can be seen in the stochastic %k and %d lines and how in the case of a bullish signal makes a series of lower highs. remember the stochastics are banded between 0 and 100 so once the stochastics hits and extremely oversold level it cannot make a lower low because there is no level lower than 0. What we are looking for is a pattern that looks very similar to a wedge pattern.
The Coiled Stochastic setup can happen on every time frame and is one of my favorites on the es 1 min time frame.
DayTraderRockStar Note: Top 3 Patterns or Set Ups that I like to trade the es with. Dual Stochastic Flag Setup, 1 Min Lane Divergence, and Coiled Stochastic Channel breakout
Knowing that Stochastics measures the relationship between an issue’s closing price and its price range over a predetermined period of time.
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Lane Divergence
This week we saw a textbook Lane divergence on the 60 min time frame and a pure divergence is not just an oversold or overbought stochastic reading it is a confirmation or a change of momentum before the price changes.
Because stochastics can get embedded, (meaning pinned in an extreme level usually above 80-90 or below 20-10) they are susceptible to false readings. When you add the 4 other indicators to the equation, you lower that risk a lot, but it is still there. The key with the stochastics is looking for a pure divergence when the stochastics make a higher low but the stock price makes a lower low. This shows the momentum slowing and shifting like a rocket that is peaking, so the price follows suit.
If the higher highs or lower lows are in price but not the oscillator, then the direction of price is likely to reverse. This is regular, or classic divergence.
The key to a Lane divergence is to spot the “potential set up ” then act on the confirmation. You can see the price has moved lower yet the stochastics have held above the recent oversold zone. This is usually the best time to start to scale in. When you have the crossover then you add. Manage the trade with your 60 min time frame for a better gauge on shorter term momentum swings.
DayTraderRockStar Tip: Even though I mention the crossover and having the stochastics start to move in the direction of the trade. I will always act on a reversal candlestick on the daily time frame. This is probably my favorite trade setup and top of the list on my playbook plays. Lane Divergence with an accompanying reversal candlestick. Please refer to the section on reversal Candlesticks to learn with patterns work the best.
Below I show you the 60 Min time frame of the same stock and you will notice we have dual divergences and this is extremely bullish (Remember even though most of the setups are buy side examples, apply the same rules just opposite for the sell side, but make sure the overall trend is in your favor)
Lane Divergences can appear on every time frame but remember each time frame is will cause your trade to move relative to that time frame so you would exit trades fast on a 1 Minute time frame versus a 60 min time frame. Here are some examples that I called live in the market. I consider these signals to be one of the best I use.
The other divergence is a Stochastic Price Divergence this divergence is an another great technique in determining a change of trend. What is key here is to see the recognized confirmed trend in the stock or index this technique works great when we are in a confirmed channel. As the price in our example makes lower lows you should see the stochastics cycle alone with the price and get oversold as the price makes lower lows. The divergence happens when the stochastics get back down into an oversold level as it had been doing in the downtrend, but the price puts in a higher low. This can usually be seen clearly in an organized channel and usually is the first signal that a breakout of the channel is approaching.
DayTraderRockStar Note: As the saying goes there are many ways to skin a cat (sorry catgirl and cat fixed) and the same is true when trading off a chart. But there is a saying I associate with the HPS methodology and that is there is one way of doing things and that is the right way. The techniques and strategies you see in this educational course have proven themselves time and time again. So much that I refuse to trade without these conditions lining up. A pure stochastic Lane Divergence is something you should learn and keep a close eye out for.
This next technique is the best timing tool I use when looking for a starting position either for a scalp or swing trade this actually is the best scalping method I use when I see it setting up.
Multiple Time Frame Entries:
Multiple time frame entries work off the 1, 3 and 5-minute time frames for scalps and remembering the 60 minute should be moving in the direction of the trade to added greater success. If the daily sets up too its a bonus and great for the longer holds.
In my 22 years of trading, I have studied many different market timing indicators. Over time I have narrowed my preference to what you see in this course. These are proven and consistent in what they are meant to do. Combined they map out the market in a very logical and scientific waypinpointingg areas of confluence and in doing this identify high probability zones.
Stochastic Spreading and Power Zones
Stochastic Combo’s
Stochastic Combos are basic 2 indicator set ups. Because Stochastics are part of the foundation of most HPS trades you will experience 2 indicators lining up (one being the stochastics) and the other could be any of the others. ( Trend Line, Moving Average, Support/Resistance, Reversal candle.) When any of those combo’s happen there is a good reason to look for a reaction in price. Remember 3 or more indicator set up is where we have 2 indicators and the stochastics lining up. This is considered a pure HPS. (High Probability Setup).
The Stochastic combo is a great technique and even though it’s not a pure HPS . These are worth trading .
