Many equity traders strive to identify stocks that are ready to break out and begin a sustained move higher in price. The difficulty lies in identifying which stocks are setting up to break out and determining when the breakout will occur.
One technique I like to use in identifying breakout setups is the Stochastic Pop. This situation arises when the stochastic indicator goes above the 70 – 80 level. Instead of reversing, however, the market tends to pop and momentum continues to rise.
The Stochastic Pop is not a new technical indicator; Jake Bernstein wrote about this phenomenon years ago. To increase the odds of success, I have added a few refinements, requiring confirming signals from both the daily average directional index (ADX) and weekly stochastic signals.
When I first showed this indicator to a colleague, he immediately named it the PopSteckler.
I identify a PopSteckler setup when the following set of conditions occur:
- Recent price action in a tight daily consolidation range
- Daily ADX below 20 and preferably, below 15 (I use a 14-day ADX)
- Daily stochastic Slow-K above 70 and preferably, above 80 (I use an 8-day stochastic. The reader is encouraged to experiment with different time frames and both Slow and Fast stochastics)
- Weekly stochastic Slow-K above 50 and rising (I use an 8-week stochastic)
- Stock breakout on above average volume (I use a 50-day average daily volume)
- Bullish market conditions.
I utilize this methodology using daily and weekly charts to trade equities. I encourage the reader to experiment with other time periods and/or other tradables.
Why the ADX?
The ADX indicator, developed by J. Welles Wilder, measures the strength of a trend but not the direction. The stronger the trend, the higher the ADX value. To better illustrate how the ADX ignores price direction, two stocks moving at the same rate but in opposite directions (one rising and the other falling) will have identical ADX values.
The longer a stock trades in a narrow consolidation (congestion) range, the less trending motion it exhibits during the lookback period. Just as a strengthening trend is measured by an increasing ADX value, a weakening trend is measured by a decreasing ADX value. Back testing revealed that when the ADX falls below 20, and particularly below 15, the stock has non-trended too long and is likely to soon break out of its trading range to initiate a new trend.
I look for stocks that have been non-trending too long. The longer and narrower the consolidation range, the lower the stock’s ADX value and the greater the likelihood that when a breakout comes, it will come hard and fast. Which direction this breakout takes and whether it leads to the start of a new trend requires the use of additional technical indicators.
Now Add the Stochastic
The stochastic indicator is a useful oscillating indicator that measures when a stock is overbought or oversold. Its classic interpretation is that a stock is overbought when the stochastic reaches a level of 70 to 80, and is oversold when the stochastic reaches a level of 20 to 30. Wait for the indicator to reverse direction and enter (or exit) your position in favor of the new direction. For example, go long (or close a short) when the stochastic is oversold and reverses higher; exit the position (or go short) when the stochastic is overbought and reverses lower.
Bernstein observed that at times stocks would continue to rise even after the stochastic reached a level of 70 to 80. The key words here are “at times.” Anticipating that a stock will continue rising merely because the stochastic rose to an overbought level not only flies in the face of conventional analysis but also involves a leap of faith that prices will continue rising. How do you know that this time the stock will continue to rise? By observing a rising weekly stochastic concurrent with an overbought daily stochastic, some of this FUD factor (Fear, Uncertainty, and Doubt) is reduced.
The logic behind this is well known to technicians: Trade in the direction of the primary trend. If the weekly trend is bullish and the daily trend is bearish, savvy traders may use pullbacks in the daily price to pyramid onto their original position. If the weekly trend is bearish and the daily trend is bullish, traders may use rising prices (particularly if they are on declining volume) to enter a short position, or may sell into a bear rally.
Piggybacking a rising (but not overbought) weekly stochastic on top of an overbought daily stochastic dramatically increases in your favor the odds of a bullish breakout and a Stochastic Pop.
Put It All Together and Wait for the Breakout
A stock with a low ADX value, a rising weekly stochastic, and an overbought daily stochastic is likely to be a breakout waiting to happen. I wait for the stock to start trading higher than the recent tight range-bound high. If volume is strong, I enter the position on the long side. Let’s look at an example.
The chart shows both daily and weekly charts in candlestick format on The Trade Desk, Inc. (TTD). I selected TTD for illustration purposes only and not as a recommendation. The daily chart is on the top and includes indicators for volume, ADX, and stochastic; the weekly chart is on the bottom and includes the stochastic indicator.
On the daily chart, note the date highlighted with the black ellipses, and the indicators on those corresponding dates. The ADX had declined in early June, 2019, trading below 15. The stochastic Slow-K was flat, trading between the upper 50’s and the low 60’s. TTD’s action had been bullish, trading above its 50- and 200-day simple moving averages.
On June 4, TTD broke out. On that date the stochastic Slow-K closed at 70.22. Volume was heavy at 178% of the 50-day average daily volume (3.084 million shares versus an average of 1.73 million shares).
On the weekly chart, that week’s ending stochastic Slow-K was at 61.13. Unfortunately, I don’t have access to the intra-week Slow-K value on June 4, but on the previous Friday, the weekly Slow-K closed at 40.47. The reader can see it rose sharply that week.
TTD closed June 4, 2019 at 222.91. There was a second PopSteckler signal the next day. By the time it finally stopped rising in late July and began moving sideways, it traded just below 280, a 25.5% gain in seven weeks.
Exit Strategies
For every trader and investor there are different investment goals and objectives, price or profit targets, time frame expectations, risk tolerances, and more. Where could an exit have been placed using the Stochastic Pop technique? That is up to the reader. Some may be looking to capture a few points while others, a few dozen points. Use an exit strategy and/or money management methodology that works best with your trading style.
Conclusion
Our goals, whether as financial advisors, money managers, traders or investors, are simple: Keep our money risk-free until the “golden opportunity” arrives to strike. Afterwards, when upward momentum slows or reverses, exit and then wait for the next opportunity to arise. Rinse. Repeat.
The less time our money is at risk in the stock market, the safer our capital remains. The PopSteckler technique is yet another tool in our technical analysis workbench to help us achieve these goals. Keep in mind that it may be considered an aggressive strategy not suitable for all investors or traders.
