Explore the Schaff Trend Cycle for Better Trading Decisions

Have you ever felt frustrated trying to identify new trends or spot reversals in the stock market at the right moment? As an investor, being able to determine market trends and potential turning points accurately is crucial for making informed trading decisions. This is where indicators like the Schaff Trend Cycle come in handy. 

In this article, we will learn how the Schaff Trend Cycle indicator works, its similarities and differences to the MACD indicator, and, most importantly – how you can effectively use it as part of your overall trading strategy. Read on to equip yourself with an advanced technical analysis tool.

What is the Schaff trend cycle, and how does it work?

The Schaff Trend Cycle (STC), developed in the 1990s by Doug Schaff, is a versatile oscillator type of indicator that aims to identify new trends early as well as warn of potential exhaustion and reversals in the existing trend. It fluctuates between 0 and 100. 

By combining several factors into its calculation, including a short-term cycle, a longer cycle and a MACD histogram, the STC produces smoothed lines designed to spot trend shifts while avoiding minor whipsaws. 

Typically, STC readings above 50 indicate an upward trend, while values below 50 signal a downward trend. As the STC approaches 70 from below, it may signify the development of a strong uptrend. Conversely, as it drops towards 30 from above, it can warn of a strengthening downtrend. Crossovers of the central 50 level can generate trading signals related to reversals. 

An STC peak followed by a drop below 50 indicates upward trend exhaustion and potential for a downward reversal. When the STC crosses up through 50, it may confirm the start of an emerging uptrend.

Some of the key strengths of the STC include:

• Earlier identification of potential trend reversals  
• Smoothed oscillator designed to filter out minor & premature signals
• Avoidance of whipsaw trades through dual smoothing
• A combination of factors, including short and long cycles 

How does the STC calculate its values?

The STC’s calculation uses three different cycles along with incorporating the MACD histogram, making it more complex than many other indicators. The typical settings involve cycles of 23, 50 and 100, although these can be customised.

Here is a brief outline of how the STC calculates its oscillator values:

1. Takes the Close price and calculates a short-term Simple Moving Average (SMA) based on the short cycle period. 

2. Calculates an intermediate SMA based on the medium cycle setting.

3. Calculates a longer-term SMA based on the long cycle.

4. Calculate a Modified Moving Average (MMA) using the three SMA values. This helps smooth out lines.

5. Calculates an SMA of the MMA to produce a dual smoothed oscillator value. This further avoids premature signals.

6. Incorporates a 10-period SMA of the MACD histogram in its formula. This adds a momentum factor.

7. Combines the smoothed SMA and MACD SMA into the final STC oscillator values ranging between 0 to 100.

As you can see, the multi-step calculation process is focused on trend identification, smoothing and early signal generation – the key aspects that make the STC a versatile and useful technical tool.

How to identify trends and reversals using the STC

Now that you understand what the Schaff Trend Cycle is and how it works let’s explore exactly how you can use it in your analysis and trading. Follow these steps:

• First, check if the STC is above or below the 50 level to gauge the overall trend bias – upward or downward
• Values over 70 suggest a strong uptrend, while values under 30 signal a strong downtrend is in play
• Watch for STC peaks above 70 as potential exhaustion points for an uptrend
• Also, observe STC troughs below 30, which may indicate a downtrend is overextended
• Crossovers of 50, along with MACD histogram trend changes, can act as confirmation for STC signals 
• An STC peak followed by a drop below 50 signals a potential trend reversal to the downside
• An STC trough followed by a push above 50 may confirm a trend reversal to the upside
• Consider 50-61 as a neutral zone where STC crossovers have less reliability 

STC strategy guide: how to use it in your trading

While the STC is useful for identifying trends and reversals by itself, it reaches its full potential when combined with overall technical analysis. Use these proven strategies to utilise the Schaff Trend Cycle effectively:

• Identify support/resistance levels: Plot historical support and resistance levels on the price chart. Crossovers taking place near these zones have higher reliability. 
• Combine with price action analysis: Factor in candlestick patterns, momentum divergences and chart pattern breakouts to confirm STC crossover signals.
• Use additional indicators: Further validate STC signals by adding indicators like the RSI, MACD or Moving Averages rather than solely relying on STC.
• Customise parameters: The default STC settings involve cycle lengths of 23-50-100, which can be adjusted if needed based on security and timeframe.
• Optimise strategy: Backtest to measure performance over past data. This will help refine entry/exit rules and fine-tune parameters.  
• Set risk controls: Use prudent position sizing, stop losses and risk-reward ratios to limit downside.

By combining the early signal benefits of the STC with robust technical analysis confirmation and trading plans, you can boost strategy efficiency.

Comparing the STC and MACD indicators  

Since the STC incorporates aspects of the popular MACD indicator in its calculations, investors may be curious about how they differ and which one to use. Let’s take a closer look at some key points:

1. Trend duration capture

The STC’s dual smoothing makes it respond slower and aims at capturing longer trends. The MACD reacts faster to short-term momentum shifts.

2. Construction and calculation  

The STC combines stochastic, RSI and moving averages for a complex formula. The MACD involves simply subtracting a longer moving average from a shorter one.

3. Components

The STC builds a MACD factor into its values. The MACD histogram provides additional trend confirmation signals.

4. Interpretation

The STC oscillates between 0 and 100, with 50 as the midpoint. The MACD fluctuates above and below zero, with positive values indicating an uptrend. 

5. Ease of use

The MACD is simpler to interpret with fewer inputs. The STC requires more optimisation but offers flexibility.

In summary, the STC focuses on early but reliable reversal signals, while the MACD excels at trend confirmation. Select the indicator aligning with your trading objectives and style. For best results, you can even combine both as they provide complementary perspectives.

Tips to effectively apply the STC in your trading

As with any powerful trading tool, the Schaff Trend Cycle requires practice and finesse to be used effectively. Keep these tips in mind:

• Use the 50-100 STC scale to gauge trend strength quickly – moves to 30 or 70 signal potentially oversold/overbought conditions signalling exhaustion.
• Factor in the speed of STC moves – rapid declines from high zones warn of sudden trend shifts.
• Smooth parameter settings reduce whipsaws but also slow STC turns, so find an optimal balance.
• Plot previous STC signals, which worked to understand its performance across market conditions.  
• Be wary of STC divergence against the price – if STC is rising while the price starts falling, it indicates tension is building up.
• Use STC on various timeframes to identify crosses having confluence across larger trends and minor swings.

Conclusion

Equipped with the insights above, traders can now look to integrate the advanced Schaff Trend Cycle indicator into their broader technical toolkit for identifying high-confidence, low-risk trade setups. Its ability to smooth out volatility while signalling exhaustion points can help time trend reversals. Combine it with chart patterns, support/resistance zones and other indicators to boost success rates. Over time, learning this cycle tool will make decoding market trends easier.

FAQs