Stochastic Indicator: Essential Guide for Momentum Trading

The stochastic oscillator is a widely used tool in technical analysis. It examines the relationship between each closing price and the recent range of highs and lows.

By measuring the ability of bullish or bearish investors to push the price close to the daily high or low, the stochastic oscillator provides valuable insights into market sentiment. Typically, rising prices tend to close near the upper limit, while falling prices tend to close near the lower limit.

What is the stochastic oscillator?

The stochastic oscillator (or stochastic indicator), developed by George Lane, consists of two lines known as %K and %D. It is based on the observation that in upward price movements, the closing price tends to be closer to the day's highs, while in downward price movements, the closing price tends to be closer to the session's lows.

The stochastic calculation incorporates the closing price of the session and the price range over a specific calculation period. The formulas used for the calculation will be explained in detail below.

Formula for stochastic indicator

The formula to calculate the stochastic indicator is:

%K=100*(C-Min)/(Max-Min)

Where:

  • C= most recent closing price
  • Min= lowest price traded for the chosen period
  • Max= highest price traded for the chosen period
  • %K= current value of the stochastic indicator

For the calculation of %K, the typical period is the last 14 trading sessions. The “slow” stochastic indicator is %D = 3-period moving average of %K. Consequently, %D provides a smoothed or flattened version of the %K indicator.

It's important to recall that a simple moving average is calculated by taking the arithmetic average of a fixed number of chosen observations. With each new period, the most recent value is included, while the oldest value is dropped from the calculation.

Stochastic indicators are often characterised as slow or fast. The fast stochastic uses the most recent price data, while the “slow” version uses a moving average. The fast one can react quicker with timely signals, but may also result in more false signals compared to the slow stochastic.

What is the stochastic used for?

The stochastic indicator's effectiveness is particularly noticeable when prices are not exhibiting strong trends. It is commonly used to identify different zigzag patterns in price movements and generates buy and sell signals.

The stochastic is a normalised indicator that ranges from 0 to 100 and includes two distinct areas or levels that hold significant importance when reached by the indicator. We interpret the following signals from the stochastic:

  • The asset is oversold if the stochastic (%K, %D) lines are in the zone between 0 and 20.
  • The asset is overbought if the stochastic lines are in the zone between 80 to 100.

Trend reversal signals provided by the stochastic are stronger when the indicator is in the overbought or oversold zone. On a chart, these areas are represented by the upper line indicating overbought zones and the lower line indicating oversold zones.

Implementing stochastic oscillator in trading strategies

We can follow the following strategies with the stochastic indicator, observing the crossing of the lines:

  • The stochastic generates a buy signal when the %K line crosses above the %D line. This indicates a potential reversal in price direction from downward to upward, suggesting it may be an opportune time to consider buying or closing a short position.
  • The stochastic indicates a sell signal when the %K line crosses below the %D line. This indicates a potential shift in price direction from upward to downward, suggesting it may be a good time to consider selling or closing a long position.

One drawback is that it is not possible to quantify the amplitude of the movement.

Another strategy involves considering the following:

  1. Buy signal: If both the %K and %D lines, after being in the oversold zone, start moving upward and exit that zone. This suggests a potential shift from a downward trend to an upward trend, indicating it may be a good time to consider buying or closing a short position.
  2. Sell signal: If both the %K and %D lines, after being in the overbought zone, start moving downward and exit that zone. This suggests a potential shift from an upward trend to a downward trend, indicating it may be a good time to consider selling or closing a long position.

Have a look at our trading guide for more information about trading strategies.

Detecting divergences with the stochastic oscillator

Another strategy to consider is based on identifying divergences in the stochastic indicator by comparing the %K and %D lines with the price data. Here's how it works:

  • Bullish Divergence: If a bullish divergence is detected, where the price is showing a lower low but the %K and %D lines are showing a higher low, it suggests a potential reversal to an upward trend. In this case, it may be suitable to consider buying and placing a protective stop order below the last price low to manage risk.
  • Bearish Divergence: If a bearish divergence is identified, where the price is forming a higher high but the %K and %D lines are forming a lower high, it indicates a potential reversal to a downward trend. In such a scenario, it may be appropriate to consider selling short and placing a protective stop order above the last price high to manage risk.

Trading using the stochastic oscillator

When the market is trending, you can utilise the crosses of the stochastic indicator outside the overbought and oversold zones to add to your positions in the direction of the trend.

In a strongly bullish market, consider increasing long positions (bullish) whenever the %K line is above the %D line. This indicates that the bullish momentum is strong and may present opportunities to capitalise on upward price movements.

Conversely, in a strongly bearish market, consider increasing short positions (bearish) whenever the %K line is below the %D line. This suggests that the bearish momentum is dominant, providing opportunities to benefit from downward price movements.

Implementing this strategy with the stochastic indicator can enhance profits in winning positions. However, it's crucial to be diligent in setting stop-loss orders to limit potential losses and manage risk effectively.

Advantages and disadvantages of the stochastic oscillator

Among the advantages of the stochastic indicator, we can highlight:

AdvantagesDisadvantages
✅ The %K and %D lines are relatively easy to calculate.❌ The stochastic indicator can identify trend changes but doesn't estimate the extent of price movement.
✅ It is a very intuitive tool that can be useful, giving clearer signals when entering an overbought or oversold zone.❌ It's primarily a visual tool and doesn't provide insights into the reasons for market shifts.
✅ It can be used with stop-loss orders to limit losses, helping to manage risk effectively.❌ To validate signals, it's advisable to wait for %K and %D lines to cross the mid-level of 50, which can lead to slower trading decisions and may not allow for rapid execution while aiming to minimize risk.

For more information, check out our article on technical analysis, or have a look at separate technical tools, such as:

To start trading, have a look at the best trading platforms and the best brokers for intraday trading.

In conclusion, the stochastic indicator is a valuable tool in technical analysis, providing insights into market conditions and potential trend reversals. Its calculation based on the relationship between closing prices and recent price ranges helps traders identify overbought and oversold zones.

While the stochastic indicator has its advantages and limitations, it can be a useful tool when combined with other indicators and proper risk management techniques.

FAQ

What timeframes are suitable for using the stochastic indicator?

The stochastic indicator can be applied to various timeframes, from intraday trading to longer-term investments. It is important to adapt the settings and interpretation based on the chosen timeframe and the specific market being analysed.

Can the stochastic indicator be used in conjunction with other technical indicators?

Yes, the stochastic indicator can be combined with other technical indicators to strengthen trading signals. Commonly used indicators alongside the stochastic include moving averages, trend lines, and volume analysis.

How should stop loss orders be utilised with the stochastic indicator?

Traders can set stop loss orders below the recent swing lows for long positions and above the recent swing highs for short positions. This helps limit potential losses in case the market moves against the anticipated direction.

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