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The stochastic pattern I trade is one of the strongest and most reliable of the price forecasting patterns. Its strength lies in its ability to sell at the top of intermediate bull market rallies or bear market corrections. The trade signal will usually be in the direction of the long-term trend, but always against the direction of the uptrend, as measured by a trendline and a simple 40-day moving average. Take a look at Figure 1, which is an image of the Treasury bond, marked with the parameter numbers for the pattern, as can be seen following:

1 The market will be in an established uptrend as defined by a trendline and the 40-period moving average. This trading system requires many trend-followers — trendlemmings, if you will — using systems that are always long at market tops and short at market bottoms. These market participants must be well-established in their positions to provide the mass exodus of selling that marks an intermediate-term top in prices.

2 The %K stochastic (the fastest stochastic line, represented by the dashed line) in an uptrend should climb above the 70 to 75 area for at least three bars — for example, for the daily, it will be three days, and for the weekly, it will be three weeks.

3A The %K stochastic should then fall below or to the 75 area, but not below 55.

3B During an extended trend with extreme stochastic %K readings of 85 or more, the %K stochastic need only fall 10 to 15 points from the stochastic high.

4A The stochastic must then climb back into the 70 to 75 area within the next five trading bars. This will give the stochastic the potential for the look of the second peak.

4B During an extended trend with extreme stochastic %K readings of 85 or more, the stochastic needs to climb and retrace a minimum of 50% of its original fall from the first peak. This will also give the stochastic the potential for the look of the second peak.

5 To remove the subjectivity from the stochastic pattern recognition system, a time frame of 10 bars from the first significant stochastic momentum deterioration is then used to time the trade and anticipate the market reversal.

More specifically, all prices contain some price patterns with

forecast reliability; all price patterns contain market momentum information. Thus, market momentum, as revealed, has forecast reliability.

Beginning with the highest price established while the stochastic was still in the uptrend, find the nearest price bar responsible for causing the %K stochastic to move lower from the first peak. How much lower is not as significant as is the loss of short-term momentum. This price bar will be the first bar of a 10-bar count.

6A A short position will then be taken on the close of the 10th bar. This position anticipates the top of the stochastic second peak. This position may or may not have divergence confirmation. To keep things simple, use the highest price of the 10-bar time frame as the stop-loss exit unless the 10th bar is the high.

6B If the 10th bar is the high, then the short position will be entered on the very first sign of market weakness within three bars from the 10th bar. This means that a position will be taken on the first lower open or lower close of any of the next three bars. The reliability of the pattern diminishes significantly if more than three bars are added from the 10th.