The Stochastic Indicator, also known as the Stochastic Oscillator, is a popular technical indicator used by technical analysts to predict trend reversals and overbought and oversold Conditions. Stochastic is an amazing tool to analyze price momentum. In this article, we will discuss what Stochastic Indicator is. How does it work, and How can you enhance your trading system?
What is Stochastic Indicator?
The stochastic indicator is a technical indicator used to measure the Momentum and trend of a security’s price. It compares the security’s closing price to its price range over a period of time. The result is a number between 0 and 100, usually displayed as a line on a chart with two horizontal lines, one at 20 and one at 80.
Stochastic is a leading Indicator, which means that Stochastic can predict a price movement before it occurs. Due to its ability to measure the Momentum of the price. The Momentum of the price generally changes before the actual change in price.
How is Stochastic Calculated?
As a general rule, Stochastic Calculated using this formula:-
%K = 100(C - L14) / (H14 - L14)
C = Latest Closing price
L14 = Lowest price of the 14-day period
H14 = highest price of the 14-day period
How to Read a Stochastic Indicator?
When reading a stochastic indicator, traders and investors look for the line to cross above or below horizontal lines of 20 or 80. If the line crosses above 80, it indicates that the security is overbought and that its price may be due for a correction. Similarly, if the line crosses below 20, it indicates that the security is oversold, and its price may move upwards.
How Can You Use a Stochastic Indicator?
Identifying Overbought or Oversold Conditions
A trader can utilize Stochastic Indicator to identify entry and exit points in the most simple and basic Stochastic Strategy. When the stochastic indicator line crosses above the 80 level, it indicates that the security is overbought, meaning its price has risen too quickly and may be due for a correction. Conversely, when the indicator line crosses below the 20 level, it indicates that the security is oversold, meaning its price has dropped too quickly and may be due to an increase.
Another Efficient way of trading with stochastic Indicators is the divergence strategy. This strategy is where traders look for an opportunity where the price of an instrument is creating new lows or highs, and the stochastic Indicator doesn’t. This can indicate that the trend could be nearing a reversal.
A bullish divergence occurs when the price of an instrument form lower lows, yet the stochastic Indicator reaches the upper limit. This means that sellers are getting strong, and the price may reverse. Conversely, a bearish divergence occurs the price of asset forms higher highs. However, the stochastic Indicator forms a lower high. This is a sign that the Bulls are gaining strength, and the price may move upwards.
It is important to note that a trade should only be taken after the Confirmation of the price change, not on the Divergence itself.
The stochastic crossover is one of the most reliable strategies. A crossover Occurs when the two lines intersect in an overbought or oversold area. If a rising %K line crosses above the %D line in an oversold area, it creates a buy signal. When a decreasing %K line passes below the %D line in an overbought region, it is a sell signal.
The crossover strategy works best in range-bound markets and should be avoided in a trending market.
Stochastic indicators are a powerful tool that can provide great insights into price momentum and trend reversals when used correctly. However, It should be noted that no tool or Indicator is perfect, and Stochastic has limitations. Therefore, using it in conjunction with other technical tools and indicators is recommended.