Using the stochastic indicator to help pick long exits

You can also use the stochastic indicator to help you determine when it's time to exit a long trade. For instance, if you're in a long position and the fast stochastic moves below the slow stochastic, that can tip you off that the uptrend may be changing to a downtrend, and the time for getting out of your long is probably drawing near.

Stochastic indicators can signal a trend change even when the stochastic readings haven't yet reached an overbought or oversold level. For an example, check out Figure 12-7 — a chart of the 30-year U.S. Treasury bond futures. I highlight a case where an uptrend changes to a downtrend outside of a stochastic indicator's overbought level. Notice, too, that some other mid-level trend changes appear earlier on the chart.

Just keep in mind that with your exits, you may need to act and get out of a trade when the fast and slow stochastics cross, regardless of whether they're in overbought or oversold territory.

I provide an excellent example of how you can combine the stochastic indicator with a candlestick pattern to identify a successful entry point and profitable exit in Figure 12-8. This chart of Plumb Creek Timber (PCL) shows the company's timber lands throughout the United States.

You can see that the entry point shows itself after a downtrend, when the stochastic levels make an upward break after spending some time under the 20 buy level. The break coincides with a three outside up bullish reversal pattern, and that combination of factors is a crystal clear indication that it's a good time to get in on a long trade. The uptrend gets going quickly after that.

Figure 12-7:

The stochastic indicator signaling a trend change on a chart of the 30-year U.S. Treasury bond futures.

Figure 12-7:

The stochastic indicator signaling a trend change on a chart of the 30-year U.S. Treasury bond futures.

Figure 12-8:

The stochastic indicator and a bullish reversal candlestick pattern provide useful entry and exit levels on a chart of PCL.

Figure 12-8:

The stochastic indicator and a bullish reversal candlestick pattern provide useful entry and exit levels on a chart of PCL.

The stock trades higher, and both the slow and fast stochastic readings move up with it. They both reach an overbought level, and then as the trend dwindles, the fast stochastic crosses under the slow one. That's a good indication that the uptrend is on its last legs, and it's especially true in this case because the crossover occurs with both stochastics above the overbought level of 80. The stock does continue to grind higher but not for long.

The final example to close out the section is a bit different from the other examples in this chapter because it's a relatively lousy trade (albeit one with a small profit) and it includes a doji (dojis are covered in Chapter 5). It's all included in Figure 12-9, which features a chart of Apple Inc. (AAPL).

Figure 12-9:

The stochastic indicator and candlesticks giving all kinds of mixed signals on a chart of AAPL.

Figure 12-9:

The stochastic indicator and candlesticks giving all kinds of mixed signals on a chart of AAPL.

The chart shows that the stochastic levels are under 20 after a short-lived downtrend. The levels then cross, forecasting the emergence of an uptrend. There's also a doji hanging out all by itself — another indication that the trend direction is about to change. The stochastic levels get over 80 pretty quickly, and the early stages of an uptrend begin to appear. It looks like it's time to buy.

But wait. Although the stochastic levels run to 80, they then cross again, indicating that the uptrend may not be around much longer. A nimble trader can recognize this sign as the time to exit and be happy with a profit, no matter how small. An even nimbler trader notices that just after the crossover to a downtrend, a bearish reversal candlestick pattern emerges.

I didn't highlight it, but if you look closely, you can see a three inside down candlestick pattern. You can also see that the stochastic readings indicate a forthcoming shift to a downtrend. Many traders see that and think that an opportunity to make some money on a short is on the way. They're wrong. The stock climbs much higher and stays overbought for some time. If a trader initiated a short position, hopefully he included a solid protective stop.

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