A stochastic shows a stock’s (or any trading instrument) ability to trade in the upper or lower part of its price range relative to the analysis period. Stocks that are in the upper part of the range (above 70) and the lower part of the range (below 30) are exhibiting signs of strength and weakness respectively, in relation to recent performance. This strength or weakness can be exploited by short term traders.
While a stochastic reading at these levels (above 70 or below 30) is often considered overbought or oversold, strong stocks will spend more time in the upper half of their range and weak stocks will spend more time in the lower half of their range. This means that we can take advantage of strong or weak stocks at points when they are showing above average strength or weakness. I call this movement a “stochastic follow through”.
The Strategy: In an up trending stock, buy when the slow stochastic line crosses above the 70 level with the fast line still pointing up. Sell a down trending stock when the slow stochastic line crosses below 30 with the fast line still pointing down. Cover longs when fast line crosses below slow line, and cover shorts when fast line crosses above slow line.
The strategy takes advantage of strong (or weak) stocks that are showing signs of accelerating even more in the current upward (downward) direction. The problem with traditional strategies using stochastics is that they often enter a trader short, for example, too early and the stock continue to rise. To avoid this, we go long with the strength in the stochastic and stock price, and then we can see once the stochastic starts dropping and price is dropping if we want to reverse.
Thus, we catch the strong tail end of a rally (or decline) and place ourselves in a good position to reverse and go the opposite way when the time is right.
Remember, indicators are derivatives of price and as such price action should always confirm what an indicator is telling us before we take the trade.