What is a Schaff Trend Cycle?

Indicators are statistics that come in handy when measuring current market conditions. In addition, they provide a great method of predicting financial or economic trends. In a broader sense, one can easily categorize them into ‘economic indicators’ and ‘technical indicators’.

What’s the difference between them? Well, for starters, economic indicators are statistical metrics that determine the growth or deflation of the economy. Specifically, as either a whole or as sectors within the economy. In fundamental analysis, economic indicators that evaluate economic and industry conditions help provide informative insight. With this, they can get an idea of the future profitability potential of public companies.

Technical indicators, meanwhile, are used extensively in technical analysis. They are great tools for predicting any potential changes occurring in stock trends or price patterns. Moreover, it can predict these changes in any tradable asset.

Trend traders will typically try to isolate and extract profit directly from trends. There are a wide variety of ways in which they can do this. Obviously, no single indicator will guarantee market riches. This makes sense, given that trading often involves various factors like risk management, as well as trading psychology. However, there are some indicators that have stood the test of time. What’s more, they maintain their popularity among other trend traders.

Among the many diverse indicators out there is the ‘Schaff Trend Cycle’, which is what this article will focus on.

What is it?

The Schaff Trend Cycle (STC) is a charting indicator that functions as a tool to help identify market trends. Furthermore, it provides traders with buy and sells signals. Its development took place back in 1999 by a notable currency trader, Doug Schaff. STC exists as another type of oscillator. Its foundation stems from the belief that – whatever the time frame – currency trends both accelerate and decelerate in cyclical patterns.

For context, an oscillator is a technical analysis tool. Its purpose is to construct high-bands and low-bands between two extreme values. Following this, it builds a trend indicator that is able to fluctuate within these bounds. Traders typically use the trend indicator as a method of discovering short-term conditions that are either overbought or oversold. As soon as the value of the oscillator approaches the upper extreme value, technical analysts interpret that the asset is overbought. On the other hand, as it approaches the lower extreme, technicians believe the asset to be oversold.

This begs an important question: what is so special about STC and why should I use it in trading? First of all, it is an easy concept to understand. In essence, Schaff Trend Cycle is your most typical oscillator; it is just given a little spice with a cycle component. Second of all, its core objective is to be a “better and more accurate version” of moving average convergence/divergence (MACD).

How it works

There are plenty of traders who are familiar with the moving average convergence/divergence charting tool. This is an indicator that helps with the predictions of price action. It is also notorious for various lagging issues thanks to its slow responsive signal line. Contrarily, STC’s signal line allows it to detect trends a lot sooner. As a matter of fact, it can identify uptrends and downtrends long before the MACD indicator is able to.

The computation of STC is with the use of the same exponential moving averages as MACD. However, it also adds a novel cycle component that provides improvements to the overall accuracy and reliability. MACD’s computation is done with a series of moving averages, the cycling aspect of STC draws from time. Particularly, from a certain number of days.

There is something else that is important to keep in mind. Even though the initial objective for STC was to primarily be for fast currency markets, you can employ it across all markets. This is not at all different from MACD. One can apply it to intraday charts, such as five minutes or one hour. It is also applicable to daily, weekly, and monthly time frames.

25 & 75

The best way to understand the readings of this indicator is to take the two thresholds into account. You have one at 25 and the other at 75. Whenever the indicator surpasses the 25 line, that indicates the observation of an uptrend. When the indicator crosses below the 75 line, it is indicative of a downtrend likely being present. Now, when the indicator falls between the 25 and the 75 lines, that means that the trend is developing. Specifically, in one of the two directions.

The indicator turning into a straight line only occurs in its uppermost and lowermost points. Whenever this happens, it means that the asset is either overbought (when above 75) or oversold (when below 25). In both cases, there is a strong chance of a trend reversal happening, but no exact timeline is available.

Applying to trading

All things considered, STC is a straightforward indicator. There aren’t that many ways in which you can use it. And again, even though its original intent was to be for a single type of trading, you can effectively apply it to all asset types and all time frames.

When the indicator rises above the 25 line, the trend is supposedly taking a positive turn. At least, according to the indicator. It’s the time in which traders consider opening a buy position, but only going forward with it upon receiving confirmation. What exactly is this confirmation? It is typically a candle following the current one that moves in the same direction. You can also interpret readings of other indicators that go in line with STC as a confirmation, too.

These same rules apply to negative trends, as well. When the indicator falls below the 75, some traders will in turn consider opening a sell position. It is, however, necessary to double-check the readings of any indicator you decide to use And yes, this includes STC.

With that in mind, what would be the best time to close the deal? The answer varies. There are some that claim it is when the indicator turns to the straight line. This means that the trend has run out of steam and a new trend is essential for opening another deal.

Calculation

The calculation process of STC is done in the following order. First comes the computation of the 23-period and the 50-period EMA and the MACD values:

MACD = EMA1 – EMA2

In this formula, EMA1 = EMA (Close, Short Length) and EMA2 = EMA (Close, Long Length).

The second step is calculating the 10-period Stochastic from the MACD values:

Schaff = 100 x (MACD – %K (MACD)) / (%D (MACD) – %K (MACD))

In this formula, %K (MACD) = %KV (MACD, 10) and %D (MACD) = %DV (MACD, 10).

In the case of the STC indicator dropping, this indicates that the trend cycle is falling. Meanwhile, the price has a tendency to stabilize or follow the cycle to the downside. In the case of the STC indicator increasing, this implies that the trend cycle is moving upward. All while the price will likely stabilize or follow the cycle to the upside.

Not a perfect concept

Before you make the decision to utilize this indicator, it is important that you also understand its notable flaws. While the STC flaunts higher reliability than MACD, it is not perfect.

It has a tendency to linger in both overbought and oversold territory for an extensive period of time. It is because of this that the most common use of this indicator is for its original purpose. That being following the signal line up and down. Moreover, taking profits when the signal line hits either the top or bottom.

Consider the following hourly chart from Standard Pro Charts. It depicts the British pound and Japanese yen currency pair, GBP/JPY.

MACD generates its signal as soon as the MACD line crosses with the signal line. The STC indicator, on the other hand, generates its buy signal when the signal line turns up from 25. In other words, to imply that a bullish reversal is happening and signaling that it’s time to go long. Alternatively, when the signal line turns down from 75, essentially indicating a downside reversal is unfolding. Therefore, the time has come for a short sale.

Take note of the fact that the STC line was able to generate a buy signal with the pair around 140.00. Moreover, it indicated that the market was overbought at 142.45, which is a 245-pip move. MACD did not do this until the move was underway. The next signal was a sell signal, whose creation was at roughly 144.00. From here, it would last until 141.50, which is a 250-pip move.

There is one main takeaway from this example. The occurrence of these moves are ahead of the buy and sell signals that the MACD generates.

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