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What is Stochastic? How to correctly read and trade with the Stochastic indicator

stochastic concept

What is Stochastic?

Stochastic is a technical analysis oscillator that compares the closing price and the previous trading range for a specific time period.

Developed by George C. Lane, the most important signal he identifies are bullish and bearish divergences forming on the Stochastic that can predict an upcoming price reversal. In other words, it signals the trend earlier than the price action. Therefore, it is considered a leading indicator.

Since it fluctuates in a range, it can also be used to determine overbought or oversold prices. Stochastic is similar to RSI These are all great indicators.

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How to calculate Stochastic indicator

Stochastic is plotted with two lines on the chart:

  • The main indicator line is called %K
  • The signal line is called %D, this is moving average (MA) of %K.

When these two lines cross, traders should look for an upcoming trend change.

%K's downward diagonal crosses the signal line showing that the current closing price is closer to the low of the indicator's specified period of time relative to the previous three sessions. This is considered a bearish signal, the opposite of this is considered bullish.

Stochastic is calculated as follows:

%K =[ (AC) / (BC) ] x 100

In which:

  • A is the last closing price.
  • C is the lowest price for the specified time period.
  • B is the highest price during the specified period.
  • The standard setting of %D is the 3 day SMA of %K.

The default set interval for Stochastic is 14 sessions and can be applied to any timeframe.

A concrete example of how it is calculated when a standard setting is established:

example of stochastic calculation

As the chart above the indicator measures 14 periods. You will find a high of 1.48 and a low of 1.448. Current closing price is 1.467 and calculate %K only:

%K = [(1.4670 – 1.4480) / (1.4800 – 1.4480)] × 100 = 59.

How to read Stochastic indicator

The Stochastic is a range-bound indicator that can be used to identify overbought and oversold market conditions.

If it is greater than 80, it reflects overbought market conditions. Below 20 reflects oversold market conditions. This indicator can only range from 0 to 100, no matter how quickly the price of the currency pair changes.

In the 14-session standard setting, an indicator above 80 shows that the pair has been trading near the top of its trading range for the past 14 sessions. A reading below 20 indicates trading near the low of the last 14 trading range.

A trend can be continuously increasing or decreasing. However, the stochastic can remain in the oversold or overbought zone for a long time.

So always trade in the direction of the trend and wait for the occasional oversold in uptrends and overbought in downtrends.

Watch now: What is Trendline? [How to draw the most accurate trendline]

Using Stochastic in Trading

Trading at overbought and oversold conditions

As explained, Stochastic is commonly used to trade in overbought, oversold conditions or for bullish and bearish divergences as well.

The example below is trading in the direction of the trend. Once an uptrend is established, how to trade under oversold conditions?

trade at stochastic oversold condition

Points (1), (2), (3) show oversold market conditions while the price is in an uptrend. That oversold level is created with each price correction. It signals the uptrend may continue.

A possible trading strategy is to enter when the %K line crosses the signal line from below. Level stop loss (stop loss) just below the previous low. It is also important to wait for additional confirmation signals like candlestick pattern such as. Oscillators are known to give false signals from time to time.

Up and down divergence

Divergence is used to identify trend tops and bottoms. Helps decide when to enter and exit a position. In this regard, divergence is a leading indicator of future price action.

Normally, both price and technical indicators should move in the same direction. A divergence in the forex market occurs when the price and the indicator do not simultaneously make a higher or lower high. That is, they are redirecting differently.

Watch now: What is the foreign exchange market (Forex)? Forex is a multi-level scam?

Below is an example of a bullish divergence on the daily chart. While the price makes consecutive lower lows, the stochastic indicator does not follow the price movement.

Instead, it made higher highs. Indicators and prices move differently. As a result, the price changed its previous downtrend to start a new uptrend.

bullish divergence

Summary

So in addition to indicator trading tools like MA, MACD, Bollinger band… or elliott wave you know one more indicator stochastic pretty awesome.

The combination of indicators is a good thing to do, because each indicator is a relative level, there is no absolute accuracy. It is advisable to make an analytical comparison using different indicators that will give an accurate judgment. From there, you will trade more successfully and increase your technique. That's it, thanks!

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