Understanding the Stochastic

It seems like one of the most common questions asked is, “What is the best indicator to use?” This, of course, is an almost impossible question to answer. Because there are so many different indicators available, as well as so many different types of trading styles, that there is not going to be “the best indicator” for all situations. Indicators come in all shapes and sizes and some may work better with certain strategies than with others. The key is to find an indicator and adjust it so it works best within the system or strategy you are trading. Once you approach using indicators like this you can use almost any indicator to your benefit. What this tells us is that it is not so much which indicator we use, but how we use it.

In our article today, we are going to discuss one specific indicator. This is not to say that this indicator should be the only one we use or that it is the best indicator to use. In fact, we could have chosen any indicator and evaluated how to best use it within our trading. In this case, we are going to look at how we can better understand the stochastic indicator, as well as how it is commonly used. Just remember that it is how we use the indicator that will dictate whether or not it will be useful in our trading.

To begin, let’s take a quick look at what the stochastic indicator looks for. This indicator was created or developed back in the 1950s by George Lane. It was created to help identify the momentum of the price movement. It can be used to identify these momentum shits by looking for divergence, as well as looking for changes in price movements when the price is in an area of overbought or oversold.

The stochastic itself is made up of two primary lines. The %k line and the %d line and they are calculated as follows:

%k = (Current Close – Lowest Low) / (Highest High – Lowest Low) * 100

%d = 3-Day Average of %k

The lowest low and highest high is for the specific time period chosen. This means that if you are looking at a 14-period stochastic, you will be looking at the highest high and lowest low over the last 14 candles or bar. There are various versions of the stochastic indicator that have been created, including the fast, the slow, and the full stochastic.

The way that this indicator is set up is that it will generally oscillate between a high of 100 and a low of 0. As the price begins to increase in price, the stochastic lines will begin to move up, and, as the price begins to decrease in price, the stochastic lines will begin to move down. This fluctuation, or oscillation, in movements will signal possible times to enter or exit a trade.

The most commonly used way to trade the stochastic is to look to buy as the price moves above the 20, after being below it, and to short when the indicator moves below 80, after being above it. This oscillation in price can show us times when it is considered overbought and oversold. Take some time to practice trading with the stochastic indicator to see if it can help you better identify times to enter and exit your trades.

How to Become a More Disciplined Trader

Becoming a more disciplined trader is very important to trading success. Successful trading is all about controlling your emotions while trading. While this is much harder done than said, it is possible if you follow a disciplined routine. One key to a consistent routine is for it to be practical because if it’s not, you will have a difficult time following through.

A disciplined routine consists of the good answers to the following questions:

–   What do you trade?
–   When do you trade?
–   Where do you trade?
–   How do you trade or what rules do you use to trade?

If you can answer these questions with specifics and then you can continue to follow the answers you have, you will become a more disciplined trader.

What You Trade
There are so many markets that you can trade, such as stocks, futures, forex, options, etc. I have found that it is better to concentrate on one or two markets and become very good at those, as opposed to trading several markets at the same time.

When You Trade
When you trade will largely be a function of when the markets that you trade are open for trading. Exchange traded markets have specific hours, but forex, for example, trades 24 hours per day. However, no one can effectively trade all day and night for very long. So determining the best hours to trade for your personal routine is very important.

One important key to deciding on when to trade is what style of trading you like. For example, if you are planning on trading stocks / ETFs or forex on a longer position basis, you will need far less time than if you want to actively trade on a shorter time frame or “scalp” trade the market, which generally requires an exclusive block of time, at a set time per day, every trading day. So, understanding what kind of trading style and what markets you are interested in in the long run will help determine what routine you eventually decide is the best for you.

Where You Trade
It is very important to successful trading that you create and control the environment that you trade in. I would suggest that you trade in an uncluttered workspace. An uncluttered workspace will have a tendency to lower your anxiety and distract you with all kinds of other things. Also, many successful traders like to have some kind of background music that you like and will put you in a good positive mood.

How You Trade
In other words, what rules or system do you use for your ‘Trading Plan’? Having a good trading plan or system, with simple entry and exit rules, is a key to disciple and controlling your emotions. Once you have a good system with good entry/exit rules, it is important that you follow or stick to them. Your trading plan should also include targets and stops so you can set up your trades using good risk management and you won’t feel the need to adjust your trades based on fear or greed.

In conclusion, it is important to have a simple routine that is practical and one that you can write down and follow consistently. The key is to make it practical and simple enough that you will follow it, which will help you control your emotions and be far more disciplined in your trading.

Reward to Risk Ratio

In today’s article, I want to discuss something that many traders look for, but most have a hard time understanding and following. The topic of this article will be that of ‘Reward to Risk Ratio’. Every time we take a trade, we are exposing ourselves to a certain amount of risk. This risk is the amount we are willing to lose during that particular trade. One of the problems that new traders (and some experienced ones) run into is not knowing how to calculate their risk. If we cannot calculate our risk, then it is hard to develop a consistent way to approach our trading. Just like our risk, we need to know how to calculate our potential reward when taking a trade. Knowing how to do this will allow us to better calculate our reward to risk ratio.

The actual calculation on the reward to risk ratio is fairly straightforward. For example, if I have a reward (profit) of $10 and a risk (loss) of $10, then my r: r ratio is 1 – this is calculated by taking my reward of $10 and dividing it by my risk of $10 to get the ratio of 1. If my reward is $20 and my risk is $10, then my ratio is 2 or 2 to 1. This would mean that for every $1 I risk, I have the potential to make $2. The higher the ratio is, the better our overall profits can become, as long as everything else is equal.

Now that we know what this ratio is representing, we should note that there are some things that we need to be aware of. The first thing is that when we first enter a trade, the r: r ratio may be different from when we exit the trade. This is especially true if we trade any way other than “set it and forget it”. If we “set it and forget it”, we can create a trade setup where we only risk $1, while looking to profit $2 on every trade. Or, in other words, we have a 2: 1 r: r ratio. If we are trading other strategies, where we move our stops or our targets, or if we close part of the trade, then the other part later, our initial r: r ratio will be much different than our actual r: r ratio. This is because we are making changes to the initial trade setups. This is fine, we just need to recognize that our actual r: r ratio is what we need to look at to see the correct number.

The other thing we need to be aware of is that the r: r ratio number is not the only thing we need to look at to tell if our strategy is profitable. We could have a very positive r: r ratio and still not be profitable if our average wins and average losses are too small or too big. So even if we have a 5 to 1 reward to risk ratio, we could be losing money if our losses are so big that they eat up our small wins.

Take some time to review your r: r ratio to see how it looks and make sure you compare it to your average wins and losses to see how well you are doing with your trading.

Uncertain Market? Reduce Your Exposure!

The S&P 500 hit a new record of 1,900 as of Friday, May 23. With the market hitting new highs, many equity traders are asking themselves, “With the markets at such all time highs, should I be in cash and out of the market completely?” Well, each trader needs to answer that question for him/herself, depending on his/her own risk tolerance. If you are completely out of the market, you may eliminate your market risk, but you’ll also cut yourself short from any potential market profits. Many pundits are all over the map on this question, which helps us to understand one thing – no one really knows where the market top is and there is a great deal of market uncertainly. With increased market uncertainty, you should consider your market exposure very carefully.

When we make any investment in the market, we are taking on risk. There is no way to avoid risk; it is just as much a part of investing life as anything else is. Risk is always present, so the only way to eliminate market risk is to stay out of the market altogether and not invest or “be in cash”. There are risks to this as well, depending on where you put your cash. One way to manage this risk is to not get out of the market, but, rather, reduce your risk be reducing your position sizes. With risk management, I recommend that you don’t risk any more than 2% of your account on any one trade or position. However, when the markets are more uncertain, you can certainly consider taking on less market exposure or, perhaps, reduce your market exposure to 1% or less of your account. This will allow you to stay active and engaged in the market while reducing you market risk. If you are not active and consistent in the market, and you jump in and out, you will almost certainly miss out on some good opportunities. For example, about eight months ago, I was speaking to a trader who was convinced that the market couldn’t go any higher and, therefore, didn’t make any more trades as the market continued to go up and he has forgone very good potential profits over the last several months. This was back in October of 2013 when the S&P 500 was below 1,700 and now it is about up around 1,900 as of last Friday’s close, with over 200 points of potential profit opportunity lost. But worse yet, once he was out of the market, he could never figure out exactly when to get back in. Now he feels it would have been much better to have stayed in the market, stayed consistent, although at a reduced position size, with reduced exposure.

So to recap, when the market is uncertain, follow your plan! Don’t jump out of the market because nobody can really time the market very well. Reduce your risk by reducing you position sizes, which will reduce your exposure to the market and will allow you to weather the market storms.

Two Moving Averages

In our article today, we are going to look at how we can use two moving averages to help us to identify the trend and the areas of support and resistance. These two things are the most important for us to identify when looking at our charts. If we can determine these things, we can then know if we should be looking to buy or sell. With the use of two moving averages, we can be aided in the identification of both of these things.

As you may know, there are many different choices we have when it comes to using a moving average. We need to choose the period we are using, as well as the type of moving average. Commonly used moving average periods should be used as these are the ones most traders are using and will tend to have the best success. Some of these periods are the 5, 10, 20, 40, 100, 200, etc. We also have to choose which type of moving average to use. The main choices will be the simple, exponential and weighted types. In the end, it really doesn’t matter so much the type or period you use, what is most important is that you are consistent with what you are using.

Once you have chosen the type and periods you will be using, you can apply them to the charts and they will begin to show you the trend and support and resistance on the charts. The advantage of using two moving averages is that they can give us a clearer picture of the direction and area for support and resistance. If you are using, for example, the 10 SMA, along with the 20 SMA, you could use the crossover points to indicate that a trend is developing. So if you are looking at a time when the 10 SMA crosses above the 20 SMA, you would be identifying the beginning of a bullish trend. If the 10 SMA crosses below the 20 SMA, you would be identifying the beginning of a bearish trend. As long as the 10 and 20 SMA remain in these alignments, you would be continuing the trend.

Because the moving averages can act as support or resistance, you can use the area between the two moving averages to help you better see the “area” where price may be slowing. Just like when we are using price for support or resistance, the area between the two moving averages will act as a similar barrier to price movement.

Once you can see the trend and support or resistance using the two moving averages, you can then begin to look for areas to enter a trade. The basic criteria for a bullish entry would be that both moving averages would be moving up and the price would have pulled back towards the area between the moving averages. The reverse would hold true when looking for a bearish entry.

Take some time to play around with the different types and periods for the moving averages and see if using two of them might help you better see the trend and support or resistance areas.

Charts – Lesson #6: Reversal Patterns

In my previous charts lesson, I discussed a couple of basic candlestick patterns, namely the doji and engulfing patterns. Today I am going to discuss a couple of additional reversal patterns.

1. Shooting Star Candlestick Pattern

The shooting star is an uptrend reversal pattern, meaning this pattern will be found at the top of the market or bullish trend. It is associated with a trend reversal from a long trend to a short trend, or Bullish to Bearish. In the diagram above, you will notice that it has a small body at the bottom of the candle and a longer wick or shadow on the top of the candle, with no lower wick or shadow beneath the candle body. The long upper wick or shadow indicates the bull’s inability to close higher and the bear’s rejection of the bullish trend. It is not important to the shooting star whether it is an actual up or down candle, either one tells the same story. This pattern indicates, in an uptrend, the loss of momentum to the upside and, perhaps, a potential reversal to the downside.

2. Hammer Candlestick Pattern

The hammer candlestick is a downtrend reversal pattern, which is the opposite of the shooting star. As illustrated in the picture above, the hammer has a small body on the top of the candlestick and a longer wick on the bottom of candlestick. It indicates a potential reversal in a bearish, downtrending market to a bullish uptrend. The long shadow indicated the bear’s inability to close lower and the bull’s rejection of the bearish trend. Also, as with the shooting star pattern, it does not matter if the actual candle is an up or down bullish candle, it is the wick and body relationship that is important.

3. Evening Star Candlestick Pattern

The evening star is a bearish reversal pattern, consisting of 3 bars in an uptrending market. As illustrated in the picture above, the first candle is a long-bodied, bullish candle, extending the current uptrend. The second candle is a short-middle candle that gapped up in the open. The third candle is a bearish, long-bodied candle that gapped down on the open and closed below the midpoint of the body of the first candle. If the pattern is found in a strong uptrend, it may be a very good indication of severe weakening of the uptrend and potential reversal.

4. Morning Start Candlestick Pattern

The morning star is the opposite of the evening star and is a bullish reversal pattern, which occurs at the bottom of a market. As illustrated above, the pattern consists of three candlesticks in a downtrending market. The first candle is a long-bodied bearish candle, extending the current downtrend. The second candle is a short-middle candle that gapped down on the open. The third candle is a bullish long-bodied candle that gapped up on the open and closed above the midpoint of the body of the first candle.

Conclusion
These four additional candlestick patterns are good indicators of a change in market sentiment and, when they occur at the either the tops or bottoms of the market, indicate a very good possibility of a change in market direction. Look for these patterns and identify any possible reversals in the charts that you follow.

Placing Stops

One of the most important things we can do when trading is to place stop loss orders to protect our money. Each position that we take, we need to place a stop loss in order to exit the trade if something goes differently than what we expected. This placement of the stop loss is critical in developing our overall successful trading methodology. If we do not have an appropriate stop loss, we open ourselves up to the possibility of catastrophic losses. Because of this, we need to make sure that any time we enter a trade, we do so with a stop loss.

Placing a stop loss in not difficult to do. In fact, most brokerages have made it part of their trading platform so it is easy to find. When you actually place it on the trade, it is usually just a matter of a few clicks and you have it placed. Even with the simplicity of placing a stop loss, there are some difficult things that traders have to deal with.

First, we need to know where the most appropriate place is to put our stop loss. Second, we need to have the discipline to actually place it. Let’s discuss each one of these issues.

1. Where to Place Our Stop Loss

This can be one of the more tricky things to learn when trading. If we put the stop loss too close, then we are increasing the probability of getting stopped out. If we put the stop loss too far away, we lose the opportunity to trade the appropriate position size. So, how do we find that “sweet” spot for placing our stop loss? Well, the truth is, there is no perfect way to know where the exact placement should be. There are, however, certain things we can look for to help us know better. The first thing we can do is to identify the support and resistance areas. Then we can make sure our stops are outside of these. In other words, we want to make sure that if we get stopped out, it is after the price has broken the areas of support and resistance. This is a common mistake that traders will make because they feel that having a tight stop loss is the best. The problem with that is that we really should be looking to place our stop at the most appropriate place, not the tightest place. The other tool we can use is the ATR to help us know if our stops are too close or not. For example, if our ATR is 20 pips, but we place our stop at 10 pips, then we are likely to get stopped out if our average movement is 20 pips. Placing our stop beyond the ATR level will help us stay in the trade through the regular movements that the chart goes through.

2. Discipline

Even if we know where we should place our stop loss, it can be difficult to place it because we are not “programmed” to do it; we need to be programmed to remember that placing a stop loss is key in our overall success. It is a bit unnatural to do something that is going to force us to take a loss, but if we understand that these losses are part of the overall plan, we can become better and it can become easier for us to place them.

Regardless of how, or what, you trade, stop losses are critical in your overall plan. Take some time to review how, where, and why you are placing your stops so you can become a more complete trader.

Charts – Lesson #5: Basic Candlestick Patterns

In our series of chart lessons, it is important to understand market sentiment, trend reversals, and some basic Japanese candlestick patterns; they are really good at helping us identify these potential reversals.

Each Japanese candlestick is a graphical representation of the price movement for a period of time covered by that candle. If the closing price of a candle is below the opening price, then a solid, or bearish, candlestick is drawn. Each candlestick is made up of two different parts, the first is the solid, or open, portion of the candle, which is known as the candle body, and is the difference between the open and close prices for a specific time frame. The second part of the candlestick, are the lines above and below the candle body, which are normally referred to as the candle wicks, or shadows, and these represent the high and low prices for that specific time frame. For example, see in Figure 1 below, if the price closes lower for the time frame, a bearish candle is formed, like on the left candle below, and if the price closes higher, then we have a bullish candle, like the candle on the right side below.

Figure 1: Candle Bodies and Wicks (Shadows)

Two basic candlestick patterns to identify market sentiment are the doji and engulfing patterns.

1. The Doji Candlestick Pattern

One of the easiest patterns to identify is the doji pattern. What is a doji candlestick? A doji candlestick is when an individual candle opens, moves up or down throughout the market period, and then closes at the same price as the open. The lengths of the wicks, the high and low, can vary from short to long. The doji pattern indicates indecision in market direction between buyers and sellers.

Figure 2: Doji Candlestick Patterns

Traders can use the market indecision indicated by the doji pattern to identify a potential weakening of the current trend. This can often trigger a price reversal in the opposite direction.

2. Engulfing Candlestick Patterns

Engulfing candlestick patterns indicate, not only indecision in the market, like the doji, but also a trend change follow through and a potential direction change in the market. Examples of bullish and bearish engulfing candles are found in Figure 3 below.

Figure 3: Engulfing Bullish Candlestick and Bearish Candlestick

The engulfing candlestick patterns are a favorite pattern among candlestick traders because they are a good indicator of a possible trend reversal. The pattern consists of two separate candles. In a bullish engulfing pattern, the first candle is a narrow range bearish candle. The next candle is a wider range candle that covers, or fully “engulfs”, the body of the previous candle and closes near the top of the range. In effect, the buyers have overwhelmed the sellers and buyers may be ready to take control and push higher.

Note in Figure 4 below, how the whole market sentiment and trend reversed at these bullish engulfing candlestick formations.

Figure 4: Bullish Engulfing Patterns

In the case of a bearish engulfing pattern, exactly the opposite happens as in the bullish engulfing pattern. The pattern starts developing at the top of the market, with the second candle being a down, or bearish, candle, completely engulfing the first, short, bullish candle, indicating a potential change in the market to the downside.

Conclusion
These two simple candlestick patterns, the single-candle doji and the double-candle engulfing patterns, can be used to help identify weak market sentiment and potential changes in the trend. Look for one of both of these two patterns on your charts to help identify shifts in the momentum.

Recognizing the Type of Market We’re In

Awhile back I was thinking about my trading and ways to improve upon what I was doing. I was probably using a few indicators at the time, which I may or may not still be using, since, over time, I have come to believe the fewer indicators and setup conditions you have, the better off you are. In most cases, the price action will tell you most of what you need to know, though there are still a few indicators that I find beneficial. While doing this mental exercise, I started to think about specific indicators and what benefit they really provide. Since all technical indicators are lagging indicators, they already have one strike against them, as far as I’m concerned. My observation of technical indicators over many years is that what you are using them for will work almost flawlessly for a time, but they will not work the same way forever. As the market itself changes, technical indicators will become more or less effective. So what works great today doesn’t work as well at some point in the future, and, depending upon which market you are trading in the future, may not be that far away. This is one of the reasons I believe that so many traders are constantly changing their approach to trading.

Changing what you are doing around your trading isn’t necessarily a bad thing, but, often times, it seems as though the method isn’t bad, it’s just that the market has changed. Recognizing that the method you are using is a good, effective method under certain market conditions, but far less effective under other conditions, is what causes the changes or the complete rewrites of trading methods, which, often times, means we’re starting over from scratch. Many trading methods do not need to be scrapped altogether, they may just need some tweaking as conditions change, or they may to be set aside until the market changes back to how it was when the method was effective. Market conditions can change for any number for reasons, from the season of the year to major world events. The point is that successful traders adapt to a changing market environment more readily than less successful traders.

I know that I have scrapped good trading methods and moved on to other methods that work better at the time, only to go back to the original method at some point in the future as market conditions dictate. Once I finally realized what I was doing, I developed a set of methods that work well for me in a given type of market and another set of methods that work well when the market changes. What this has shown me is that if I want to be a successful trader, I must always watch the overall market to evaluate what type of market we are currently in to determine which of my methods will be the most successful. This isn’t necessarily a day-to-day change because we can be in a particular market type for an extended period of time. But when I notice that the method or methods that I am employing is/are becoming less and less successful, I am now able to recognize that the reason for this isn’t because the methods are flawed, it is simply because the market has changed. The change will last for a given period of time and, at some point, it will change again, which may bring it back to how it was before the change.

I notice this more in a fast moving market like the Forex market, which makes a lot of sense due to its speed versus the stock market. Where the stock market seems to be in a particular cycle or market type for extended period of time, the Forex market changes far more quickly. The problem isn’t the method itself, the problem is the trader is applying the wrong type of method to the changing market environment.

Price Swings

In our article today we are going to discuss the importance of market swings. In the past, we have looked at the importance of the deliberate price action needed when we are trading and, as part of that, we can include the importance of being able to identify swings within the market. Market swings are what makes up the fundamental patterns we are looking to trade. Just as price action makes up the swings, the swings make up the patterns.

These patterns can be as basic as tops and bottoms, head and shoulders, flag, triangles, or any other price pattern that is made. Knowing how to identify these will put us in a better place to know when to enter a trade. As you identify these common price patterns, you will have a stronger setup if the price action is happening within deliberate moving swings.

Maybe the most basic pattern that price swings make is the swings shown within an up or down trend. As a review, we can look at the following as a way to identify these trends.

Uptrend – The price action that forms the pattern of higher highs and higher lows. Each of these highs and lows are price swings. As the swings are moving up, they will form the uptrend.

Downtrend – The price action that forms a pattern of lower lows and lower highs. Each of these lows and highs are price swings and form the downtrend on the chart.

As we look at price swings, we want to also make sure they are deliberate in their movements. This means we do not want to see price that moves up strongly, then down sharply, and call it a bullish swing; this type of movement is not considered deliberate. What we would like to see in the price swing is multiple bullish candles, followed by multiple down candles. This is even better when we see a small body candle, or multiple small body candles, forming at the top of the swing. The reverse would hold true for a down swing, where we see multiple down candles, followed by multiple up candles, also having small body candles at the bottom.

In many types of trading strategies, the deliberate swing is an important part of the setup. For example, if you were looking to take a bullish trade, you would not want to enter as the price reaches the peak of the upswing. Rather, you would want to wait until the price pulls back and swings to the down side. This swing low will allow you to identify if the price has run into some support and then you can enter in as the price begins to bounce up.

As we look to identify price action, patterns, as well as when to enter and exit a trade, we will be wise to look for deliberate swings in price. Take some time to look at your chart to make sure you can identify these deliberate swings. They will help you in knowing the best time to enter your trade.