How to Trade Stochastics: AJ Monte’s Secret Weapon

How to Trade Stochastics: AJ Monte’s Secret Weapon

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Market Rebellion’s Lead Technical Analyst, AJ Monte, has decades of technical analysis know-how under his belt. Yet, despite having an in-depth understanding of dozens of technical indicators, AJ only regularly relies on three.

Pictured: The SMA, the stochastics, and the CCI, all set up on AJ Monte’s screen.

In this article, we’ll be covering how AJ Monte uses the stochastic indicator to uncover technical trade ideas day in and day out — and how you can too.

Looking to brush up on your knowledge of the other two indicators AJ deploys — the SMA and the CCI? Discover why these three indicators are the holy trinity of technical analysis, and how you can use them in conjunction with one another to add conviction to your trade ideas.

What are the Stochastics?

The stochastics are a technical indicator widely used by option traders to identify potential timely buying and selling opportunities in the market. The indicator is based on the principle of overbought and oversold conditions. 

In other words, the stochastics help traders to identify when a particular asset is becoming overbought or oversold, which can indicate a potential reversal in the market. That means, just like a gravestone doji, the stochastics are best used to predict the end of an already established trend (more on that later).

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How to Trade Using the Stochastics

The first step in understanding how to trade with stochastics is to understand the basic principles of how the indicator works. Stochastics are a momentum indicator that compares the closing price of a security to its price range over a given period of time. 

The indicator is measured on a scale of 0 to 100, with values above 80 indicating an overbought condition and values below 20 indicating an oversold condition. 

This is similar to the RSI, which measures overbought conditions using a different calculation, is measured from 0 to 100, and considers a security overbought when the measurement is above 70 — and oversold when the measurement is below 30. Essentially, when a trend is established, you’ll watch the stochastics as they are above 80 or below 20 for a sign that the trend is soon to end. 

If the trend is bullish, and the stochastics reach an overbought condition above 80, that’s a bearish signal that a reversal in trend could be coming. Likewise, when a stock is trending bearish, but the stochastics are rocketing towards that sub-20 level, that’s a bullish signal that a reversal may be afoot. 

But it isn’t as simple as buying when the stochastics are sub-20, and selling when the stochastics are above 80. There’s one more thing traders must do when using the stochastics. 

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Knowing When to Strike: Identifying Divergence

When attempting to identify entry and exit points in the market, we have to be a little more nuanced than simply buying calls on oversold stocks. Skilled option traders know time is always of the essence — that’s why they often wait for a divergence to make their move. 

VOCAB CHECK: DIVERGENCE: In plain speak, a divergence is a separation between two entities or items. 

In our case, we’re searching for a “divergence” between the direction of the stochastics, and the direction of the stock or security. But divergence isn’t specific to the stochastics. 

You can have a wide divergence between the stock and the simple moving average — when combined with other similar indicators, that can be a sign that the security will start heading back toward the moving average. 

You can also have a divergence between “overbought/oversold” indicators like the RSI and the CCI! When many of these indicators are giving the same directional reading, you can begin to craft a technical trade thesis. Let’s look closer at the example above from our Lead Technical Analyst, AJ Monte.

Example of How to Use Stochastics

In the trade idea above, AJ Monte is examining the Vaneck Semiconductor ETF (SMH), which is in a short-term (7-candle) defined uptrend. 7 green candles — that’s a lot for a sector which has been taking on water all year. In the example above, we’re now well above the 20-day SMA — in other words, there’s a growing divergence between the SMA and the stock.

Additionally, even though the stock is continuing to rally, the volume is dropping. That means there’s a divergence between the direction of the volume and the direction of the stock. 

On top of that, the blue line of the stochastics is well above the overbought area, and hinging downwards. That’s another form of divergence — even though the stock is moving upwards, the stochastics are now moving downwards. 

Lastly, the story behind the CCI (another indicator used to determine whether a security is overbought or oversold) is exactly the same as the story behind the stochastics — overbought, hinging downwards, forming a divergence between the trend of the stock and the indicator itself.

On their own, each of these wouldn’t be meaningful enough to indicate a reversal in trend — but when combined with one another, the strength of the signals begin to stack up, and that’s where a trade idea begins to take shape.

Use the Stochastics in Combination with Other Technical Signals to Predict the End of a Trend (Or Take Your Trades From Someone Who Does)

When trading with stochastics, it is important to remember that the indicator is a lagging indicator and that it can be affected by other market conditions. As a result, traders should always use stochastics in conjunction with other technical indicators to make informed trading decisions — indicators like the CCI, the RSI, volume, and moving averages.

Stochastics are a powerful technical indicator that can help traders to identify potential buying and selling opportunities in the market. By understanding the basic principles of the indicator, the different types of signals that it generates, and how to use it to identify entry and exit points in the market, traders can use stochastics to make profitable trades. 

However, it is important to remember that the indicator is a lagging indicator and should be used in conjunction with other technical indicators to make informed trading decisions.

We know, it can be a lot to take in. Technical analysis is something we believe anyone can understand — with enough practice. But if you’re looking to skip the line, we’ve got you covered

Realistically, we would always recommend paper trading using these signals and the strategies we’ve taught in this article before deploying them yourself in a real brokerage environment. It’s easy for a new trader to slip up, misread a signal, or forget their discipline. 

We’ve all been there early in our trading career. However, for traders looking to dive right in, we recommend a low-cost way to do exactly that with help from our Lead Technical Analyst, AJ Monte. 

Using the indicators above, AJ Monte regularly identifies technical trading opportunities, like this one below. When AJ identified this trade on December 28th, Tesla was trading at $110.30, and these February 17th $145 options (which were $35 out of the money) cost $4.00. 

At the time of writing, Tesla is trading above $157, and these options (which are now in the money) have traded for as much as $20.40 — more than 5X the original trade price.

AJ’s Options Essential offers multiple trade ideas like this one provided with video explanations every week. AJ will tell you exactly how much he’s risking, what option he’s buying, what signals he’s seeing, and he’ll walk you through it step-by-step. These aren’t long videos — these are 3-6 minute videos, provided on a regular basis, featuring nly the most important details. Interested in trying it out? Visit this link.

Not sure yet? Get more acquainted with AJ for free through his Weekly Market Reports. Subscribe today for free weekly technical analysis on the major indices.

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