Most Effective Strategies to Invest in Stocks using Stochastic Chart

Most of us struggle these days while saving money for our future needs. Earlier interest rates were high, but over a period of time they have come down. Trusted sources offer lesser rates. The new and risky ventures offer higher rates. Therefore, I prefer investing in businesses that are flourishing in this country.

 

Today I was going through YouTube where various experts have spoken their heart out in different videos. So many of them talk about which stock will go up and which one will not. But I don’t look into those. Personally, I do not buy or sell stocks based on what others have said. I do my own homework. Yes, I do consider expert opinions to narrow down my search.

Anyways I was looking at various indicators and oscillator. It is overwhelming to see how many such videos are there on these topics. Finally, I picked up stochastics. That’s what today’s study will be on.

A stochastic oscillator is a momentum indicator comparing a particular closing price of a security to a range of its prices over a certain period of time. The sensitivity of the oscillator to market movements is reducible by adjusting that time period or by taking a moving average of the result. It is used to generate overbought and oversold trading signals, utilizing a 0–100 bounded range of values.

Two important things to consider:

There are two important things to consider in stochastics; i.e %K and %D. Notably, %K is referred to sometimes as the fast stochastic indicator. The “slow” stochastic indicator is taken as %D = 3-period moving average of %K.

The general theory serving as the foundation for this oscillator is that in a market trending upward, prices will close near the high, and in a market trending downward, prices close near the low. Transaction signals are created when the %K crosses through a three-period moving average, which is called the %D.

I got to know that stochastic acts differently in range bound market and trending market. So that needs to be interpreted in the correct manner. Then came the topic of fast and slow stochastic. Lower valuation generates more signals which is called the fast stochastics. Many of these signals can be false. But on the other hand, the signals generate quickly. So, this one is highly sensitive. I can take a buy or sell decision quickly.

If I increase the timeframe or the valuation then stochastics become slow. Signals are rare to generate, but they are genuine (mostly). The problem here is that signals generate late. Therefore, when I am thinking of buying or selling the stock price has already moved up or down. Thus, if you need more signals then lower settings is correct. Otherwise, if you need to reduce unnecessary signals then higher valuation is correct. Stochastic for higher time frame can be 8. 3. 5. Depending on the stock market condition, the stock that I have chosen and the time frame for which I intend to hold it I will have to adjust the valuation or time frame of stochastics. It is basically a trial-and-error method. You have to do it by yourself.

Interpretations of Stochastics:

1. There are 2 lines in a stochastic chart. One is at 80 and the other is 20. If the oscillator is below 20 then it indicates an oversold situation. Generally, this is where one needs to buy. On the contrary when it is above 80, it is called an overbought zone. This is where selling starts. However, there is more to this. Although books say that this indicator shows overbought above 80 and oversold below 20, this does not work in a trending market. Where the stock price is moving up stochastics will remain above 80 and will vary between 60 to 80. Thus, shorting the market thinking that it is overbought is a grave mistake.
2. Next is crossover in stochastics. This is reliable in a trading market and partly reliable in a trending one. In an uptrend we need to consider only the buy crossovers. In a downtrend we rely on the sell crossovers. But since I am writing about investment, I will focus only on the buy side in an uptrend. Maybe the most elegant approach is to look for the price crossover divergences. When stock price is making a higher low and the stochastic is making a lower low it indicates a buy in an uptrend. When stock price is making a lower high and the stochastic makes a higher high then it is a time to sell in a downtrend. Determine the main trend with a trendline or a moving average. Then look for hidden divergences on the side of the trend
3. One more way of using stochastic is that when it crosses above the 50 mark it is a buy sign and when it crosses below this mark it gives a sell sign. 13.3.5 is the setting for long term. But there are no fixed settings for all stocks for all different time frames. We need to check individually. The best settings for using indicators depends on our understanding of the indicator and the purpose of using the same. In my case it is to find entry point for long-term staying.

So that’s all that I have learnt.

While looking at the Nifty 50 stocks I was getting confused with the support lines and exactly how often does this strategy work. So, I pulled up everything in an excel sheet, i.e all the 50 stocks. For support lines I used straight lines, i.e channels, moving averages, and Fibonacci lines. Since I am a long term investor, I have chosen monthly chart. I think this is better, as I am an office going person it is not possible for me to keep a track of stock price every day. I have even burnt my fingers trying trading. Thus, long-term investing to harness the power of compounding suits me.

Based on whatever I have learnt till now, I did a lot of testing with various types of support lines and stochastics of various times frames. 20, 50, and 100 months moving average usually worked. However, once I even took 25 and for another stock it was 30 months.

Out of 50 stocks the strategy has worked for 33 stocks. Of course, not all are equally strong signals. The reason why I am doing this experiment is because I tend to select fundamentally strong stocks and enter at the time when the price is low. It is true that nobody can time the market. But I can buy a stock at a cheaper rate than what my friend has bought it for.

Things to remember:

1. Fast stochastics will give more signals but less reliable.

2. Slow stochastics will give less signals, more reliable but also lagging.

3. Overbought territory is usually considered as above 80. Oversold territory is generally below 20.

4. Choose monthly chart for long term investing.

5. There is no universal valuation of stochastic. It varies on stocks and the time frame chosen.