Stochastic Indicator & Trading Strategies

The stochastic indicator is one of the most powerful and commonly used technical analysis tools. It belongs to the momentum oscillators group of indicators that help traders establish overbought and oversold conditions in the market. Other indicators that belong to this group include the RSI, MACD and TRIX. Stochastics was developed in the 1950s by George C. Lane, and its purpose is to assess the momentum of an asset’s price as well as the overall strength of the prevailing trend. As a measure of price momentum, the stochastic indicator can be very versatile in its functionality. In trending markets, it can warn of potential retracements or even reversals; and in ranging markets, it can tell when the underlying trend strength is fading. This makes stochastics a handy technical analysis tool in all market conditions to help pick out trading opportunities in the perpetual cycles of an asset’s price.

Stochastics Calculation

The stochastic indicator features two lines (%K and %D) that are calculated as follows:

%K = [(Current Close – Lowest Low n periods ago) / (Highest High n periods ago – Lowest Low n periods ago)] * 100
%D = 3-period moving average of %K

The default n period on most trading platforms is 14, but traders can choose their desired time period against which they wish to assess price behaviour. Generally, a smaller n will result in a stochastic that will react faster to price changes, but this may also generate an unreliable signal in some instances. On the other hand, a bigger n will result in a stochastic that reacts slowly to price changes, but the trading signals generated will be more reliable. Also, %K will be faster than %D (its moving average).

Reading Stochastics

The two stochastic lines oscillate between 0 and 100. The indicator has two distinct lines drawn at values ‘20’ and ‘80’. The values denote oversold and overbought conditions in the market, respectively. George Lane pointed out that in the market, price follows momentum. Therefore, when prices are in overbought territory, traders can look to sell when the %K line crosses the %D line downwards. Similarly, when prices are in oversold territory, traders can seek buy opportunities when the %K line crosses the %D line upwards.

The above interpretation is ideal in ranging markets. Traders must be wary of stochastic signals in markets that trend strongly because indicator values can stay for prolonged periods in overbought and oversold conditions.  Traders also watch the stochastic centreline (value 50) because it tells whether the prevailing trend is momentous or not. A bullish trend is qualified as momentous if the stochastic reading is above 50; whereas a bearish trend is qualified as momentous if the stochastic reading is below 50. Beyond the indicator reading, traders can also watch out for stochastic divergences to pick out lucrative trading opportunities in the market.

Trading Stochastic Indicator Signals

Here is how to trade the signals generated by the stochastic indicator:

• Overbought and Oversold Conditions
  This is particularly ideal in ranging markets where there are defined support and resistance levels. To place a buy order in a support area, the stochastic reading must be below 20, and the %K line must cross the %D line upwards. Likewise, to place a sell order in a resistance area, the stochastic reading must be above 80, and the %K line must cross the %D line downwards.
• Stochastic Straight Divergences
  Stochastic straight divergences can help traders pick out potential price reversals in the market early enough. A bullish divergence occurs when prices are making lower lows, but the stochastic indicator makes higher lows in the oversold territory. This is a signal to buy because the bearish price movement lacks momentum. A bearish divergence occurs when prices are making higher highs, but the stochastic indicator makes lower highs in the overbought territory. This is a signal to sell because the bullish price movement lacks momentum.
• Stochastic Hidden Divergences
  While straight divergences help traders to forecast potential reversal points in the market, hidden stochastic divergences help traders to pick out optimal entry points in a trending market after a retracement has occurred. In an uptrend, the idea is to look for bullish hidden divergences so as to place buy orders. A bullish hidden divergence occurs when the price makes higher lows, but the stochastic indicator makes lower lows around the oversold territory. In a downtrend, the idea is to look for bearish hidden divergences so as to place sell orders. A bearish hidden divergence occurs when the price makes lower highs, but the stochastic indicator makes higher highs around the overbought territory.

Professional Stochastic Indicator Strategies

The stochastic indicator is at its best when combined with other technical analysis tools. Here are some of the best combinations:

• Stochastics and Pivot Points
  Pivot Points is a popular indicator that derives multiple support and resistance lines. These lines can provide definitive price zones where traders can watch out for stochastic trade signals. A high probability trade signal is delivered when there is a confluence between the two indicators. For instance, a high-quality long trade can be entered when a buy stochastic signal occurs on a Pivot Points support line.
• Stochastics and Moving Averages
  Moving Averages (MAs) are ideal for trading trending markets because they smooth out price action. When multiple moving averages are applied, traders watch for MA crossovers to qualify a trend. When combined with stochastics, traders can pick out great opportunities in trending markets. The logic is to trade in the direction of MAs but eliminating potential false signals using stochastics. For instance, when a faster MA crosses a slower MA upwards, it implies an uptrend is in place. Traders can then go long when stochastics delivers buy signals.