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Lesson 7: Stochastic

Lesson 7: Stochastic

Stochastic oscillator is a popular technical indicator because it is easy to understand and has a relatively high degree of accuracy.

The stochastic indicator is classified as an oscillator, a term used in technical analysis to describe a tool that creates bands around some mean level. The idea is that price action will tend to be bound by the bands and revert to the mean over time. The indicator provides buy and sell signals for traders to enter or exit positions based on momentum.

How to use this guide

To get the most out of this guide, it’s recommended to practice putting these stochastic indicator trading strategies into action. The best risk-free way to test these strategies is with a demo account, which gives you access to our trading platform and $10,000 in virtual funds for you to practice with. Get your free demo account.

Once you’ve found a strategy that consistently delivers positive results, it’s time to upgrade to a fully-funded live account where you can apply your newfound edge.

What is a Stochastic Oscillator?

The STOCHASTIC indicator shows us information about momentum and trend strength. The oscillator analyses price movements and tells us how fast and how strong the price moves.

This is a quote from George Lane, the inventor of the STOCHASTIC indicator:

“Stochastics measures the momentum of price. If you visualize a rocket going up in the air – before it can turn down, it must slow down. Momentum always changes direction before price.” – George Lane, the developer of the Stochastic indicator.

The basic premise of the technical trading indicator is that momentum precedes the price, so the Stochastic Oscillator, being a momentum indicator, could signal the actual movement just before it happens.

The stochastic indicator can be used by experienced traders and those learning technical analysis. With the help of other technical analysis tools such as moving averages, trendlines, and support and resistance levels, the stochastic oscillator can help to improve trading accuracy and identify valuable entry and exit points.

How to calculate the stochastic oscillator

The stochastic indicator is a two-line indicator that can be applied to any chart. It fluctuates between 0 and 100. The indicator shows how the current price compares to the highest and lowest price levels over a predetermined past period. The previous period usually consists of 14 individual periods. For example, on a weekly chart, this will be 14 weeks. On an hourly chart, this will be 14 hours.

When the stochastic indicator is applied, a signal line will appear below the chart. This is the %K line. There will also be another line on the chart, which is the three-period moving average of %K. This is referred to as %D.

stochastic indicator
Source: CAPEX WebTrader

To calculate the signal line, a trader will need to subtract the lowest price over the period from the most recent closing price. They will then divide this by the highest price over the period minus the lowest price. The formula for the stochastic oscillator is as follows:

The calculation for %K:

%K = [(C – L14) / H14 -L14)] x 100

Where:

  • C = latest closing price
  • L14 = Lowest low over the period
  • H14 = Highest high over the period

The calculation for %D:

%D = simple moving average of %K

Now, let’s look at an example of Tesla’s share price. From the chart below, we can see that the 14-period low was $754,31, while the high was $1117,67. TSLA’s stock closed very near the period high, at $1087,50. So, the stochastic oscillator line would be calculated as follows: [(1087,50 - 754,31)/(1117,67 - 754,31) x 100] = 91.69%

This figure indicates that the closing price was extremely near the top of the asset’s 14-period trading range – we’ll go on to what this means in a moment.

stochastic indicator example
Source: CAPEX WebTrader

How can you use a stochastic oscillator in trading

When you see the stochastic signals and you want to place a trade, you can do so via derivatives such as CFDs. Derivatives enable you to trade rising as well as declining prices. So, depending on what you think will happen with the asset’s price when one of the Doji patterns appears, you can open a long position or a short position.

Follow these steps to trade when you see the stochastic signals:

  • Trading any type of technical indicators requires patience and the ability to wait for confirmation. The appearance of one of these Stochastic signals alerts traders of a price reversal, but until that occurs, most traders leave the pattern alone.
  • To get started trading stochastic oscillators, open an account. Choose between a live account to trade CFDs straight away or practice first on our demo account with virtual funds.
  • Choose your financial instrument. Stochastic signals can be spotted in most financial markets, especially those that are more volatile, such as forex, cryptocurrencies, and stocks.
  • Explore our online trading platform. We offer a wide range of technical indicators that are not limited to stochastic, as well as providing a range of order execution tools for fast trading, which in turn helps you to manage risk.

The below strategies for trading stochastic signals are merely guidance and cannot be relied on for profit.

Stochastic overbought/oversold strategy

In a basic overbought/oversold strategy, traders can use the stochastic indicator to identify trade exit and entry points.

Generally, traders look to place a buy trade when an instrument is oversold. A buy signal is often given when the stochastic indicator has been below 20 and then rises above 20. In contrast, traders look to place a sell trade when an instrument is overbought. A sell signal is often given when the stochastic indicator has been above 80 and then falls below 80.

Stochastic overbought/oversold strategy
Source: CAPEX WebTrader

However, overbought and oversold labels can be misleading. An instrument won’t necessarily fall in price just because it is overbought. Similarly, an instrument won’t automatically rise in price just because it is oversold. Overbought and oversold simply mean the price is trading near the top or bottom of the range. These conditions can last for a while as the chart above shows.

Stochastic divergence strategy

Another popular trading strategy using the stochastic indicator is a divergence strategy. In this strategy, traders will look to see if an instrument’s price is making new highs or lows, while the stochastic indicator isn’t. This can signal that the trend may be about to reverse.

A bullish divergence occurs when an instrument’s price makes a lower low, but the stochastic indicator touches a higher low. This signals that selling pressure has decreased and a reversal upwards could be about to occur. A bearish divergence occurs when an instrument’s price makes a higher high, but the stochastic indicator hits a lower high. This signals that upward momentum has slowed, and a reversal downward could be about to take place.

Stochastic divergence strategy
Source: CAPEX WebTrader

An important point in relation to the divergence strategy is that trades should not be made until divergence is confirmed by an actual turnaround in the price. An instrument’s price can continue to rise or fall for a long time, even while divergence is occurring.

Stochastic crossover

The stochastic crossover is another popular strategy used by traders. This occurs when the two lines cross in an overbought or oversold region.

When an increasing %K line crosses above the %D line in an oversold region, it is generating a buy signal. When a decreasing %K line crosses below the %D line in an overbought region, this is a sell signal. These signals tend to be more reliable in a range-bound market. They are less reliable in a trending market.

Stochastic crossover
Source: CAPEX WebTrader

In a trend-following strategy, traders will monitor the stochastic indicator to ensure that it stays crossed in one direction. This shows that the trend is still valid.

Stochastic bull/bear strategy

Lastly, another popular use of the stochastic indicator is identifying bull and bear trade setups. A bull trade setup occurs when the stochastic indicator makes a higher high, but the instrument’s price makes a lower high. This indicates that momentum is increasing, and the instrument’s price could move higher. Traders often look to buy after a brief price pullback in which the stochastic indicator has dropped below 50 on the pullback and then moved higher again. A bear trade setup occurs when the stochastic indicator makes a lower low, but the instrument’s price makes a higher low. This signals that selling pressure is increasing and the instrument’s price could move lower. Traders often look to place a sell trade after a brief rebound in the price.

Combining the Stochastic with other tools

When combined with other indicators, the stochastic indicator can help a trader identify trend reversals, support and resistance levels, and potential entry and exit points. Price should retrace to a key support level to consider a crossover in an oversold area.

Combining the Stochastic with other tools
Source: CAPEX WebTrader

Moving averages can be a great addition here and they act as filters for your signals. Always trade in the direction of your moving averages and if the price is above the moving average, only look for longs – and vice versa.

Price formations such as wedges and triangles also work well with stochastic indicators. When price breaks such a formation with an accelerating Stochastic, it can potentially signal a successful breakout.

Stochastic divergence or Stochastic reversal can be traded nicely with trendlines. For example, the trader could monitor an established trend with a valid trend line and wait for the price to break the trend with confirmation from the stochastic indicator.

How you choose to use the stochastic oscillator will depend on your personal preferences, trading style, and what you hope to achieve. Stochastic can be used in short-term trading like scalping and day trading, and in swing trading in combination with pivot points.

However, there are a few key points that everyone who uses this momentum indicator should know:

  • The stochastic oscillator is a momentum indicator, which compares the most recent closing price relative to the previous trading range over a certain period
  • It is a leading indicator, as it’s based on the idea that market momentum will change direction must faster than volume or price increases
  • The stochastic oscillator is formed of two lines on a price chart: the indicator itself (%K) and a signal line (%D)
  • The stochastic oscillator is a bound oscillator, which means it operates on a scale of zero to 100. A reading over 80 is an indication the market is overbought, while a reading under 20 shows oversold conditions
  • The most common use of the stochastic oscillator is to identify bullish and bearish divergences – points at which the oscillator and market price show different signals
  • It can also be used to identify bull and bear set-ups, points that indicate increasing momentum in the opposite direction
  • It is often likened to the relative strength index (RSI), another momentum indicator. However, the RSI is based on the speed of changing prices, rather than historical prices
  • When you spot a stochastic signal, you can trade using derivatives such as CFDs
  • With derivatives, you can go long or short because you do not own the underlying asset

Free trading tools and resources

Remember, you should have some trading experience and knowledge before you decide to trade candlestick patterns. You should consider using the educational resources we offer likeCAPEX Academyor ademo trading account. CAPEX Academy has lots of courses for you to choose from, and they all tackle a different financial concept or process – like the basics of analyses – to help you to become a better trader.

Our demo account is a great place for you to learn more about leveraged trading, and you’ll be able to get an intimate understanding of how CFDs work – as well as what it’s like to trade with leverage – before risking real capital. For this reason, a demo account with us is a great tool for investors who are looking to make a transition to leveraged trading.

FAQs

What is the difference between the stochastic oscillator and relative strength index?

The stochastic oscillator and relative strength index (RSI) is both momentum oscillators, which are used to generate overbought and oversold signals.

Despite both being used for similar purposes, to identify price trends, they are based on very different theories. The stochastic oscillator is based on the idea that the closing price will remain near historical closing prices, while the RSI tracks the speed of the trend.

Both oscillators work on a zero to 100 scale, but their signals also vary. The RSI would indicate the market is overbought if it reaches above 70, while the stochastic oscillator would need to reach 80. And the RSI would consider the underlying asset undersold if the indicator was below 30, while the stochastic oscillator would need to fall to 20.

What is the difference between stochastic oscillator and MACD?

MACD and Stochastic are two types of technical analysis that attempt to produce signals for investors on possible security price trends, although they do so in vastly different ways. The MACD, also known as the Moving Average Convergence-Divergence, relies upon moving averages, which are average stock prices over a period of time, to anticipate stock trends. By contrast, the Stochastic Oscillator depends upon a formula based on current stock prices along with their highest high prices and lowest low prices of the recent past. Both MACD and Stochastic provide signals at certain points on price charts where there is a crossover between two lines.

What are the best stochastic oscillator settings?

You must choose first, how much noise of data you’re ready to accept for your trading method. The more knowledge you have with the indicator, it will enhance your sustaining of probable signals. Some professional day traders choose the low setting like 5,3,3. Some choose a high setting like 21,7,7 for long-term trading. Because a highly smoothed outcome only responds to the key changes in the price action.

What is Stochastic RSI?

The Stochastic RSI is an indicator that applies the formula of the stochastic oscillator to a set of Relative Strength Index (RSI) values, rather than a set of stock prices.

The stochastic oscillator utilizes a stock’s price movements in relation to defined support and resistance levels, while RSI calculates momentum based on the comparison of closing prices over a period. The two technical indicators were combined to increase the sensitivity to fluctuations in the price and produce a more thorough indication of upward or downward price momentum.

Due to its increased sensitivity to market fluctuations, the Stoch RSI can be useful for traders looking to gauge a stock’s relative momentum. It’s a particularly useful tool in low volatility stocks, as price movements tend to be more pronounced. Stocks and other assets, such as crypto, which exhibit high levels of volatility can produce multiple false signals, as the RSI moves within a hard-to-define range over relatively short periods of time. As with most technical indicators, signals should be cross-referenced with other metrics and fundamental analysis.

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