What is the Stochastic indicator
Stochastic constitutes a reliable momentum oscillator, conceived by George C. Lane in the middle of the previous century. It consists of two moving averages which move in defined boundaries, between 0 and 100.
The Stochastic indicates where the price of the underlying asset is closed in relation to its price range in a predefined period of time. The default time period is 14 days. Obviously, the sensitivity of the indicator depends on this fixed period, as all the calculations are based on this.
Assuming a 14 days fixed time-period, here is the formula that the Stochastic is based on:
%K = 100 * (CP – L14) / (H14 – L14)
C: previous losing price
L14: Lowest price of the last 14 days
H14: Highest price of the last 14 days
%K: The percentage of all the previous closing prices, during the defined period, for which the closing prices are below the most recent closing price.
%D: It is plotted on the Stochastic indicator and considered the signal line. This is just a moving average of three periods of the aforementioned %K.
Slow and fast stochastic
What makes the fast stochastic different than the slow stochastic is the sensitivity and this depends solely on the settings of the indicator. Its common sense that slow is not as sensitive as fast Stochastic. As a rule, the more sensitive is a technical indicator the more trading signals it gives.
The formula described in the previous section is considered the fast Stochastic. To reduce the indicator’s sensitivity and therefore the number of false signals, stock and Forex market traders conceived the slow Stochastic.
To create the slow stochastic first we must apply a simple moving average of three-periods to the Stochastic %K. This replaces the fast-Stochastic K%. Then the signal %D is calculated as usually, a three period SMA (simple moving average), based on the new slower %K. In other words, the %K of the slow Stochastic is equal to the %D of the fast Stochastic.
Stochastic indicator signal
A crossover signal can take place anywhere in the per-defined price range between 0 and 100. When the two lines cross then we get a transaction signal. Its is a buy signal If the Stochastic line %K crosses above the %D signal line. It is a sell signal when the Stochastic line %K crosses below the %D signal line.
Oversold-overbought signal. When the price of the underlying security is moving above 80% of all the previous closing prices, then the security is considered overbought and it signals a short (sell) trade.
In case the current price is moving below 20% of all the closing prices in the per-defined time-period, the security is considered oversold and thereby this is a signal to go long (buy) it.
Stochastic divergence signal assumes that the price of the underlying asset is not moving in accordance with the direction of the indicator.
While the price of the security makes a new high while at the same time the Stochastic makes a new low, we assume that the uptrend is exhausted, and the reverse of the direction is imminent. So, this is considered a signal to short (sell) the underlying asset.
A bullish signal (buy signal) is indicated in case the security’s price is making new low but the Stochastic is making a new high.
Often the timing of the Stochastic divergence is not accurate. Also, it should never be our only criterion to initiate a trade. Likewise, crossover and oversold-overbought signals should always be verified using additional technical indicators and preferably fundamental information as well.
How to define the market context
A common trap for many beginner traders is to use oscillators, for example the well-known Stochastic Indicator, without taking into consideration the current context of the market.
Using profitably the Stochastic Technical Indicator in your day trading, it assumes that you can identify the right market conditions.
An overbought or oversold market does not mean necessarily the exhaustion or reverse of a trend. A market can stay for a long time in an extreme state and keep moving in the same direction. Additional confirmation is needed for any trading decision.
Like any other day trading indicator, Stochastic oscillator can be used in many ways in day trading, depending on the various market conditions.
One of the most reliable ways to trade is buying the pull back when the market is in uptrend or selling the pull back when the market is in downtrend. In these conditions, a corresponding signal from the Stochastic indicator is quite reliable.
Ranging markets can be trickier for the new traders. The Stochastic indicator is recommended over the RSI indicator under these market conditions. RSI measures how fast the price moves and thereby is preferable over the Stochastic in trending conditions.
The famous Stochastic indicator, like any other indicator, is just a tool for stock and forex market technical analysis. It is recommended all three different signals that can be produced by this indicator to be combined, in order to provide a more reliable trading signal.