Using the stochastic indicator to help pick a long entry point

You can use the stochastic indicator to determine a good time to buy a stock if you watch for instances where the slow and fast levels both trade below the oversold level of 20, and then the fast stochastic crosses over or goes higher than the slow stochastic. I've always felt confident in the stochastic indicator because of that feature; even though the levels are technically oversold, it's not truly a buy signal until the trend starts to move just a little bit higher. And it's even more comforting when you combine it with a bullish reversal candlestick pattern. You can see what I mean in Figure 12-5.

Figure 12-5 is a chart of Johnson Controls (JCI), a manufacturer of large systems and parts for cars and buildings. The company is very much tied to the overall economy, and I like trading it for that reason.

The chart begins with a downtrend. The slow and fast stochastic levels trade below the oversold level of 20. Then a three outside up reversal pattern appears on the chart, when the stochastic levels are still well under the 20 level. But the second two days of this pattern are very bullish, and the slow and fast stochastic readings start to move higher. The icing on the cake is a cross of the fast stochastic over the slow. The stochastic indicator is indicating an uptrend, the stock has been oversold, and a bullish reversal pattern has developed on the chart. It's the perfect time to put on a long position!

Figure 12-5:

The stochastic indicator and a bullish reversal candlestick pattern signaling a buy on a chart of JCI.

Figure 12-5:

The stochastic indicator and a bullish reversal candlestick pattern signaling a buy on a chart of JCI.

The trend that follows the sequence of events in Figure 12-5 is pretty impressive. It's so strong that the stochastic indicator stays in an overbought state for several weeks.

You can see another example of how you can combine the stochastic indicator with a bullish reversal pattern in Figure 12-6. The chart in this figure is of the stock TXU, a Texas utility that was taken private while I was in the process of writing this book.

Figure 12-6:

The stochastic indicator and a bullish reversal pattern signal a buy on TXU.

Figure 12-6:

The stochastic indicator and a bullish reversal pattern signal a buy on TXU.

The stock has clearly been in a downtrend. (Note that the downtrend occurred after a bearish pattern appeared on the chart a few weeks prior — aren't candlesticks great?) The stochastic readings reach the oversold level, and a three outside up pattern develops. At just about the same time, the fast stochastic moves above the slow one, signaling a change in trend from down to up. It's time to buy, buy, buy! The uptrend continues for several weeks, and a savvy trader who identifies the combination of the stochastic indicator and the bullish reversal pattern will have her profits piling up.

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