1. Open a Chart
For faster, wider-ranging stocks with news or momentum, you will
want to use a 15 tick candlestick chart with
For slower, steadier stocks with less momentum and high volume (MSFT,
INTC, CSCO, INTC, you may be better
with a one minute candlestick chart with auto-scale. On these slower
ones there are too many identical ticks
a minute’s time, making a 15 tick chart tedious and redundant.
2. Add Stochastic
3. Add Moving Averages
P = 5 and P = 15
4. Change Colours
Catman recommends green for the 5 MA, red for the 15 MA, and yellow
for the %K. I use a dark grey background.
colours make sense for reasons we will get into later, but the important
thing is that the set-up is clearly
and aesthetically pleasing to you.
A sudden sharp drop in %K to 0 and an upward curving in the 5 MA
This is the first early signal indicating a bottoming.
This is used as either a high-risk/high-potential long entry … or
… early conservative exit for shorts
A crossing of the 5MA above the 15MA
This is the second, lagging or confirming signal indicating a bottoming.
This is used as either a lower-risk/lower potential long entry …
or… later exit signal for shorts
A sudden sharp spike in %K to 100 and a downward curving in the
This is the first early signal indicating a topping.
This is used as either a high-risk/high-potential short entry …or…early
conservative exit for longs
A crossing of the 5MA below the 15MA
This is the second, lagging or confirming signal indicating a topping
This is used as a lower risk/lower-potential short entry... or…
later exit signal for longs
The signals themselves
are clear and easy to read. The hard part is understanding how to
use them! The idea is
to the way a traffic-light works. At every traffic-light, the first
warning signal before traffic changes direction is a
light. The second signal to stop is then a red light. In some European
countries the yellow light even works both ways. When you are stopping
it first turns yellow, then red. When it changes again, it first
turns yellow and then green.
As a driver, you have to choose what to do when the light turns
yellow. You can either wait for green, or go ahead at the early
yellow signal. You can either stop early when the light turns yellow,
or speed up to get through the intersection.
whenever you make a move on an early yellow signal, you accept more
risk. What if you decide to move ahead at
first yellow signal before it turns green, and someone going the
other direction is trying to hurry up before their side
red? You might make it to your destination faster if you act on
yellow, but you are accepting more risk.
The same is true with this system. Whenever you act on an early
signal, there is usually more potential. At the same
you are also taking on a greater risk of being stopped or not seeing
much follow-though. This is generally true for
trading system really. More volatile stocks will move a lot further,
but also a lot faster. The greater the potential
the greater the risk. There is always a payoff. So how you combine
these signals will depend on several factors including your skill
at executing stops, your risk threshold, and how consistently the
market has been offering follow-through.
Case of Microstrategy (MSTR:Nasdaq) on November 2, 2004
look at MSTR and I will try to explain how this works.
From the short side…
At this time we see a spike in %K to 100, but no topping. Why not?
You want to keep your eye on the 5 MA, because that’s your guide.
Notice how at this time the 5 MA was still
straight up, and there was still a pretty wide channel between the
5 MA and the 15 MA. As long as the
MA holds above the 15 MA, the stock is still in an upward trend.
In conjunction with a %K spike to 100, we need
appearance that the 5 MA is flattening out, or curving - that the
channel may be closing. Its really the
of the second signal, which would be the actual crossing of the
5 MA below the 15 MA.
Another %K spike has just occurred, but this time there’s also a
curving in the 5 MA that leads you to
the channel closing. This is a good topping signal. Shortly afterward,
at around 11:44am, we then see
second signal for topping, an actual crossing of the 5 MA below
the 15 MA. That’s our confirmation.
Any top is either an exit for longs or an entry for shorts. For
the sake of this example, let’s say we are shorting
top. Our first short opportunity would be the high-risk/high-potential
signal - the %K spike to 100 and
5 MA curving, which occurred at about 11:43am.
Why is it high-risk? Because we don’t know how much follow-through
we will see. We don’t yet know whether
going to actually cross MAs, confirm and keep going down. We don’t
know if we will get a second signal.
could have easily topped at 11:43am and come down a bit, but as
the MAs tested at 11:44am they could have
apart, not crossed, and curved back up. In that case we would want
to exit, either near the entry price or with
As it turned out, the MAs crossed, which was a confirmation for
the early shorts or a later short opportunity.
We see a sharp %K drop to 0 and an upward curving in the 5 MA.
This is the signal for either a high-risk/high-potential long entry
or an early conservative exit for shorts. So with our
position we have two choices; we either exit, taking surest conservative
profits, or we trail our stop, waiting for
the second signal of bottoming, the 5 MA crossing above the 15 MA.
Let’s say, for the sake of this example, that
decide to trail our stop, waiting for the second signal.
We see another sharp %K drop to 0, with an upward curving in the
5 MA. This time though, following the %K drop
also see an actual crossing of the 5 MA above the 15 MA at around
12:04pm. That is our cue to exit the short.
From the long side…
Now let’s look at the same example from the long side. Remember,
a sharp drop to 0 in %K with an upward curving
5 MA is also a high-risk/high-potential long entry signal.
So let’s say we decided to enter long at the 11:46am %K drop, as
the 5ma began curving upward.
The stock began climbing, from about 64.01 to 64.45, but then dropped
down again. At about 11:50am the MAs
came closer together, but they did not cross. Instead, the 5 MA
backed off and turned downward again. This would
be a stop; maybe around the entry price, maybe with a tiny gain.
At the time of the MA test, the price was still
entry at 64.15, but the trade is still stopped because the cross
did not happen. Also notice the %K headed
down as well.
At 11:53am we saw another sharp drop in %K to 0 again. Long opportunity?
No. Look at what the 5 MA was doing.
It was still heading almost straight down without much of a curving.
Shortly afterward though at 11:56am we see another %K drop to 0
with a better curving in the 5 MA. This is another
opportunity, and at 12:04pm we see the second confirming signal,
a cross of the 5 MA above the 15 MA.
But what happened after that? The stocked climbed from 63.50 to
64.09, but then we saw a %K spike to 100, which
is an early conservative exit signal. The MAs did not really widen
apart or form a long channel. Instead, the 5 MA
back down and crossed below the 15 MA at 12:12pm, a second exit
signal. There wasn’t that much
after the MA cross, so in this case clearly the conservative exit
would have been the better choice.
note about discipline…
If you look back
over charts and track all signals throughout the day, you will soon
see that some of them have ample
and some are small scalps. The 11:56 bottom on MSTR was worth mere
pennies if you had trailed
while the 11:43 short would have yielded around 80 cents with trailed
stops. You won’t know until they develop,
so it often pays to act on all the set-ups. The good thing is that
risk is small because the stops are clear. So you have
little to lose and a lot to gain by following all the signals. And
if you are diligent, you can easily rack up several points
This is also an important key to overcoming emotional trading. Forget
the money, forget the price of the stock even,
focus on the signals and set-ups. Keep stops when its appropriate
and hold on until you see an exit signal.
the signals and rely on them. By putting your focus on the signals,
it will minimize emotions and keep you
from second-guessing your decisions, which is a deadly trading error.