The stochastic indicator is a popular technical analysis indicator that is useful for predicting trend reversals. Developed by Dr George Lane in the 1950s, this technical indicator focuses on price momentum. It can be used to identify overbought and oversold levels in stocks, currencies, indices, and many other investments.
Stochastics measure the momentum of price movements. Momentum is the rate of acceleration in price movement.
The idea behind the stochastic indicator is that the momentum of an instrument’s price will often change before the price movement of the instrument actually changes direction. As a result, the indicator can be used to predict trend reversals.
The indicator works by focusing on the location of an instrument’s closing price in relation to the high-low range of the price over a set number of past periods. Typically, 14 previous periods are used. By comparing the closing price to previous price movements, the indicator attempts to predict price reversal points.
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, trend lines and support and resistance levels, stochastics can help to improve trading accuracy and identify profitable entry and exit points.
The stochastic indicator is a two-line indicator that can be applied to any chart. It fluctuates between 0 and 100.
%K = 100(C - L14) / (H14 - L14)
C = the instrument’s most recent closing price
L14 = the instrument’s lowest price of the 14-day period
H14 = the instrument’s highest price of the 14-day period
When the stochastic indicator is applied, a white line will appear below the chart. This white line is the %K line.
There will also be a red line on the chart, which is the three-period moving average of %K. This is referred to as %D.
The stochastic indicator is scaled between 0 and 100.
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.
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.
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.
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.
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.
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.
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.
Traders should be aware that the stochastic indicator does have limitations. It is not a foolproof technical analysis tool. The indicator can often generate false signals. During choppy market conditions, this can happen frequently.
In conclusion, the stochastic indicator is a useful technical analysis tool that can be used to identify overbought and oversold instruments.
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CMC Markets does not endorse or offer opinion on the trading strategies used by the author. Their trading strategies do not guarantee any return and CMC Markets shall not be held responsible for any loss that you may incur, either directly or indirectly, arising from any investment based on any information contained herein.In conclusion, the stochastic indicator is a useful technical analysis tool that can be used to identify overbought and oversold instruments.
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