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Stochastic Indicator – What you need to know
Alex

LEVEL 10 : SENIOR

REVIEWS 9 | REPLIES 84

#2693

Alex

October 12, 2015 at 12:53 pm

The Stochastic indicator has been around since the late 1950’s. You will see most traders who trade with indicators, will have a Stochastic Oscillator on their chart. The funny thing about this is that most of them don’t even know how to use it for its intended purpose. They just throw it on their charts and follow some random advice they got from the internet. Traders that tend to do this will inevitably end up in failure. Novice traders will pick an indicator and ask other people how to use it. Professional traders, on the other hand, will research the indicator as much as possible and learn everything he can about it before using it in his trading. After reading this article, you will see that everything you thought you knew about Stochastic indicators were all wrong.

What Is a Stochastic Indicator?

Most people think that the Stochastic Indicator is designed to show oversold or overbought prices. How often have you looked at your charts and saw that the Stochastic is in the overbought or oversold areas, but the price just won’t seem to turn? That’s because this indicator has nothing to do with oversold and overbought areas. What the Stochastic indicator does is provide you with information regarding the momentum and strength of a trend.

“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, developer of the Stochastic Oscillator indicator.

Stochastic-indicator

Figure 1 – Example Of a Stochastic Oscillator

How Does The Stochastic Indicator Work?

The Stochastic analyzes a price range over a chosen time period. The most common time period settings are the 5 and 14 periods. What the indicator does is it takes the absolute high and low during that period, and it then compares it with the closing price of the last candle. Stochastic indicators are measured with the help of the %K and %D line. The formula for the %K line is as follows:

%K = (Current Close – Lowest Low)/(Highest High – Lowest Low) * 100

Mathematically, the %D line looks like this:

%D = 3-day SMA of %K

*Lowest Low = Lowest low for the predefined period
*Highest High = Highest high during predefined period

Let’s have a look at two examples to understand better how it works:

1)How to calculate a Stochastic high

  • The lowest low of the previous 5 candles: $60
  • The highest high of the last 5 candles: $100
  • The close of the current candle: $95
  • %K line: [(95 – 60 ) / (100 – 60)] * 100 = 88%

When the Stochastic closes ($95) near the top of the range ($100) it will cause a high value (88%) which indicates a strong uptrend.

2)How to calculate a Stochastic low

  • The lowest low of the last 5 candles: $50
  • The highest high of the previous 5 candles: $80
  • The close of the current candle: $55
  • %K line: [(55 – 50 ) / (80 – 50)] * 100 = 17%

When the Stochastic closes ($55) near the bottom of the range ($50) it will cause a low value (17%) which indicates a strong downtrend.

I only show you these calculations for interest sake. Metatrader and other charting programs will automatically calculate and plot these values on your charts.

What The Stochastic Indicator Cannot Do

  • It can’t tell you if the market is overbought when the Stochastic is above 80 or oversold when it’s below 20.
  • The indicator can’t show whether the trend is going to continue or not.
  • Most importantly, Stochastic Oscillators alone can’t give you solid entry signals.

How Can You Use a Stochastic Indicator?

There are various ways of using the Stochastic Oscillator. There is no right or wrong way, as long as it works for you. Here are 2 ways how you can incorporate the Stochastic indicator into your trading strategy.

Trend Strength

The first way that you can use this indicator for is to use it for what it was originally developed to do – engage the momentum and strength of the trend. In order to do this, you need to use a larger timeframe than what you normally use to take your trades from. In the example below we use a 1-hour chart. We see that the Stochastic is above the 80% level between the two gray lines on the chart that tells us that the momentum is up.

trend-momentum

Figure 2 – 1hour Stochastic Shows Momentum Is Up

Now we need to go down to our preferred trading timeframe. Let’s use the 5-minute timeframe for this example. Knowing that the momentum is up, we should start looking for buying opportunities. If we used price action for our entries, we could have taken at least four call trades between the two gray lines.

binary-options

Figure 3 – 5minute Buying Opportunities

The above scenario will be opposite in a downtrend. The Stochastic will be below the 20% level. Then you will need to go down a few timeframes to spot selling opportunities.

High and Low Trades

I know I said that the Stochastic indicator does not display overbought or oversold conditions, but it doesn’t mean that you can’t use it for that purpose. The best way use the indicator for this is first to identify the overall trend. This could be done by making use of any of the three methods we discussed in Trading The Trend – Part 1 article. You can also look at a Stochastic on a higher timeframe to enter the 20 or 80 region to identify where the momentum of the trend is. In Figure 4 below we can see that the Daily momentum is up due to the Stochastic being above the 80% level.

daily-momentum

Figure 4 – Overall Trend Momentum Up

Now if we go down to a smaller timeframe, we need to look closely at the Stochastic. When the %k and %D line crosses in the 20% region and goes above the 20 level we can take a call trade, but only if the price action supports the trade. In Figure 5 below we could have taken a call trade each time the Stochastic dipped under the 20 level. These five call examples were confirmed through the use of candlestick patterns. If you don’t know what candlestick patterns are, please have a look at our Basic Candlestick Patterns article.

call-binary-options

Figure 5 – Stochastic Call Trades

Conclusion

The settings you use with the Stochastic Oscillator will depend on your personal preferences, trading style and the time frame you trade. However, you need to remember that a short look-back period will present a very choppy oscillator that will cause the indicator to be above 80 and below 20 almost all the time. A longer look-back period will show a much smoother oscillator which in return causes the indicator not to be above 80 or below 20 too often. A longer look-back period will give more reliable information than a shorter look-back period will. Like all indicators, you should use the Stochastic Oscillator in conjunction with other Technical Analysis tools for more confirmation.

This article will make you think twice before believing anything you hear. There is a scary amount of wrong knowledge being shared among traders. Do your own research and build your trading knowledge as much as you can. You are never too old or good to learn something new!

Chris Larson

LEVEL 1 : NEWBIE

REVIEWS 0 | REPLIES 3

#2769

Chrissie

October 20, 2015 at 6:12 pm

You have to be joking with me… no wonder I was losing the whole time when I was using the stochastic indicator. I have been using it the wrong way. If only I knew this earlier! Oh well better late than never they say.

Ken Farmer

LEVEL 1 : NEWBIE

REVIEWS 1 | REPLIES 2

#2770

Ken11

October 21, 2015 at 11:37 am

Well heck if I think about it, it actually makes sense to use the stochastic this way. Thanks for the great article man. It has opened a whole new way for me to look for trades. Also very nice trading examples. I love it when you add trading examples to your articles. It makes so much more sense when I see what you are talking about on a chart. Thumbs up

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