The widely accepted belief that markets can’t be timed is typical conventional thinking. In reality, markets are timed every trading day by numerous algorithmic trading programs. Timing as it applies to forecasting and trading the direction and magnitude of a price move within a specific span of time. Going against conventional wisdom, markets can be timed with higher probability within shorter time spans and increase in complexity with longer time spans. High-frequency trading (HFT) programs time market moves in millisecond time spans. Considering it takes 300 milliseconds to blink an eye, that’s a pretty tiny time span. By utilizing the right technical indicators and chart patterns, traders can improve their probabilities of successfully timing trades. The key is spotting the right moments where the price action is most conducive to timing, which requires an effective arsenal of technical tools and knowledge of recurring patterns. One of the most vital tools is a momentum indicator, the stochastic oscillator
The Stochastic Oscillator
This technical momentum indicator is commonly found on most online charting platforms. Composed of two stochastic lines that oscillate in a range between zero and 100 (referred to as bands). The two stochastic lines are the %K stochastic and the %D stochastic which is a dynamic moving average of the %K. As the two stochastic lines crossover each other and fluctuate in the range, they will signal overbought conditions when they cross above the 80-band and signal oversold conditions when they fall below the 20-band. The stochastic oscillator functions very much like n car’s tachometer indicating the engine is redlining at the 80 and 20 bands.
Settings for Stochastic
Depending on the charting platform, the inputs for the stochastic may vary. An effective three-input setting is %K = 15, %D = 3 and Smoothing = 5. Some platforms may label the inputs as %D, %D slow and Smoothing. The same 15, 3, 5 combination of inputs apply as well.
Don’t Make These Common Rookie Mistakes
Keep in mind that just because a stock signals overbought or oversold, they can continue to stay at these levels for extended lengths of time. A common mistake made by new traders is to short-sell stocks as they rise above the 80-band only to get squeezed higher or buy stocks under the 20-band stochastic only to have price continue to sell-off. As a caveat, the longer a stochastic remains under the 20-band or above the 80-band before ultimately reversing back through can result in stronger directional price moves.
The key to buying into an oversold price bounce is to wait for the stochastic lines to cross each other back up above the 20-band for confirmation. The 20-band is a vital bounce trigger akin to a coiled spring, therefore, timing your entry as the stochastic cross up is the key for precision buys. On the flip side, selling or short-selling when the stochastic crossover back under the 80-band is the trigger for timing a price sell-off.
Reversal Triggers at the 80/20 Band Stochastic
The basic application of the stochastic oscillator involves timing entries and exit on the 80/20 band crossovers for triggers. For buy signals, wait for the stochastic to fall under the 20-band and buy when the stochastic crosses back up through the 20-band. For sell signals, wait for the stochastic to rise through the 80-band and sell when the stochastic falls back under the 80-band.
Initially, training to time on a smaller time frame like a 1-minute chart reinforces accuracy. However, the tools are linear through all time frames, it’s a matter of adjusting to the larger price swings and holding periods. Longer time period produces more noise, so it’s best to practice with smaller time frames initially especially for intra-day trading.
Building a Strategy by Combining Patterns with Indicators
Integrating a consistent price action pattern (MSL) with a momentum indicator (stochastic) can improve outcomes with higher probability timing opportunities. Using the MSL pattern to identify a reversal bottom trigger is helpful. By adding the stochastic oscillator to confirm the 20-band crossover trigger then enables you to have the wind on your back as the fresh momentum surge provides liquidity and visibility. Grouping standalone components synergistically is how to develop a strategy. Sounds like the Avengers? This particular strategy is to buy when an MSL pattern triggers combined with a 20-band stochastic crossover up. The exit triggers as the stochastic approaches the 80-band or when the stochastic oscillators cross back down.
Evolution of a Methodology
To build a methodology, you have to spot the instances when the strategy fails. Identifying the context and factors that contribute to the failure is the only way to patch the leak until everything comes around full circle. These two components are just the start of a journey towards galvanizing a trading methodology. In future articles, I will add more indicators that visually identify both dynamic and static price support and resistance levels as well as patterns embedded into technical indicators that enable on-the-fly interpretation of price action complete with rules for trade management. The objective is to generate a ‘cumulative effect’ that enhances market timing and augments a trader’s agility managing the trade, the sum of all parts to maximize probability while minimizing risk.