The Set-Up…


1. Open a Chart

For faster, wider-ranging stocks with news or momentum, you will want to use a 15 tick candlestick chart with

auto-scale.

For slower, steadier stocks with less momentum and high volume (MSFT, INTC, CSCO, INTC, you may be better

off with a one minute candlestick chart with auto-scale. On these slower ones there are too many identical ticks

in a minute’s time, making a 15 tick chart tedious and redundant.

2. Add Stochastic

%K (P=14)

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.

These colours make sense for reasons we will get into later, but the important thing is that the set-up is clearly

visible and aesthetically pleasing to you.

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The Signals…

 
BOTTOM SIGNALS

Signal 1.

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


Signal 2.

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



TOPPING SIGNALS

Signal 1.

A sudden sharp spike in %K to 100 and a downward curving in the 5 MA

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


Signal 2.

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

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Using the Signals…

The signals themselves are clear and easy to read. The hard part is understanding how to use them!  The idea is

similar to the way a traffic-light works. At every traffic-light, the first warning signal before traffic changes direction is a

yellow 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.

But whenever you make a move on an early yellow signal, you accept more risk. What if you decide to move ahead at

the first yellow signal before it turns green, and someone going the other direction is trying to hurry up before their side

turns 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

time, you are also taking on a greater risk of being stopped or not seeing much follow-though. This is generally true for

any trading system really. More volatile stocks will move a lot further, but also a lot faster. The greater the potential

reward, 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.

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The Case of Microstrategy (MSTR:Nasdaq) on November 2, 2004

Let’s look at MSTR and I will try to explain how this works.


From the short side…

11:40am

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

pointed straight up, and there was still a pretty wide channel between the 5 MA and the 15 MA. As long as the

5 MA holds above the 15 MA, the stock is still in an upward trend. In conjunction with a %K spike to 100, we need

the appearance that the 5 MA is flattening out, or curving - that the channel may be closing. Its really the

"anticipation" of the second signal, which would be the actual crossing of the 5 MA below the 15 MA.

11:43am

Another %K spike has just occurred, but this time there’s also a curving in the 5 MA that leads you to

anticipate the channel closing. This is a good topping signal. Shortly afterward, at around 11:44am, we then see

the 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

this 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

its going to actually cross MAs, confirm and keep going down. We don’t know if we will get a second signal.

It could have easily topped at 11:43am and come down a bit, but as the MAs tested at 11:44am they could have

held apart, not crossed, and curved back up. In that case we would want to exit, either near the entry price or with

a small gain.

As it turned out, the MAs crossed, which was a confirmation for the early shorts or a later short opportunity.


11:46am

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

short 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

we decide to trail our stop, waiting for the second signal.


11:57am

We see another sharp %K drop to 0, with an upward curving in the 5 MA. This time though, following the %K drop

we 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.


11:46am

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

above entry at 64.15, but the trade is still stopped because the cross did not happen. Also notice the %K headed

back down as well.


11:53am

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.

11:56am

Shortly afterward though at 11:56am we see another %K drop to 0 with a better curving in the 5 MA. This is another

long 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

headed back down and crossed below the 15 MA at 12:12pm, a second exit signal. There wasn’t that much

follow-through after the MA cross, so in this case clearly the conservative exit would have been the better choice.

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A 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

follow-through and some are small scalps. The 11:56 bottom on MSTR was worth mere pennies if you had trailed

stops, 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

a day.

This is also an important key to overcoming emotional trading. Forget the money, forget the price of the stock even,

and focus on the signals and set-ups. Keep stops when its appropriate and hold on until you see an exit signal.

Watch 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.