It is usually considered that the best signals come when the stochastic crossover occurs when the stochastics are above 80 percent or below 20 percent. These two levels give the most room for the signals to make money since the signal occurred when the market was overbought or oversold. Once again, I am not sure that this is so since selling into overbought bull markets is a dangerous game. Still, those are the usual rules.
Sometimes the %K will cross the %D when the %D is still climbing. This is called a left-handed crossover because the %K crosses over the %D on the left-hand side of the “hump” created by the %D. This will occur when the price changes sharply in the other direction. A right-handed crossover comes when the %K crosses over the %D on the right side of the “hump” of the %D. Figure 5.2 shows examples of both types of crossovers.
Most analysts prefer the right-handed crossover because they believe that it is a more stable market and that they are entering the market just after the turn in prices. A right-handed crossover will only occur when the market stabilizes first and then starts to drop. A right-handed crossover will also have the benefit of usually having both the %K and %D moving in the same direction when the crossover occurs. It is for this reason that many investors prefer right-handed crossovers. It means that the momentum has changed significantly and that a trend has likely started.
However, the inventor of stochastics, George Lane, has suggested that it is acceptable to trade a left-handed crossover if it represents a resumption of the main trend. In particular, he suggests using it when a classic divergence (to be discussed next) has occurred and the left-handed crossover represents a resumption of the trend.
Stochastics can also cross over in the middle of the range between 20 and 80. They don’t have to cross over only in the extremes of the stochastic range. Crossover will usually occur in the middle of a major trending market, that is, the market moves strongly in one direction, reverses, and then takes off again. Stochastics can give a sell signal during that retracement only to reverse back to the direction of the trend immediately after.
Generally, the idea is to buy or sell on the crossover and liquidate the trade on a crossover in the other direction. Obviously, this doesn’t give much protection against sudden and strong moves in the wrong direction. As a result, many traders put in some protective stop based on recent price action, such as support and resistance, as disaster insurance against such a powerful move against the position.
Let me go back to the concept of trading crossovers in the middle of the range rather than at the extremes. I like this method because we are no longer using the concept of overbought and oversold, which I believe is very dangerous to our equity. But let’s get back to the concept of using stochastics to tell us the momentum of the market.
We see that there is a strong trend in the market and that there has been a retracement. Now we want to use a crossover in the %K and %D only in the direction of the trend to enter a position. We have essentially used the stochastics to time the end of countertrend move and then get back in tune with the strong underlying trend. This way of using stochastics is very profitable. Please note that you need to find another way to set a protective stop. Typically, you will use the low of the countertrend move as the stop.
Source: Trading Signals From Crossovers In Stochastics
