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

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stochastic concept

What is stochastic?

Stochastic is an oscillator indicator in a technical analysis that compares the previous close and trading range for a specific period of time.

Developed by George C. Lane, the most important signal he identified was that the bullish and bearish divergences forming on Stochastic could predict the upcoming price reversal. In other words, it signals the trend earlier than the price movement. So, is considered a leading indicator.

Because of fluctuations in a range, it can also be used to determine overbought or oversold prices. Stochastic is similar RSI are a great indicator.

Watch now: What is technical analysis? Tutorial for beginners

How to calculate the Stochastic indicator

Stochastic is drawn with two lines on the chart:

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

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

The downward sloping line of% K crosses the signal line, which shows that the current closing price is close to the lowest of the designated period of the indicator compared to the previous three sessions. This is considered a bearish signal, in contrast to this is considered a bullish price.

Stochastic is calculated as follows:

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

In which:

  • A is the nearest closing price.
  • C is the lowest price in the specified time period.
  • B is the highest price in the specified period.
  • The standard setting of% D is a 3-day SMA of% K.

The default time period set for Stochastic is 14 sessions and can be applied to any time frame.

A specific example of how the calculation when the standard setting is set:

Example of stochastic calculation

As the chart above measures 14 stages. You will find the highest price is 1.48 and the lowest is 1.448. The current closing price is 1.467 and calculated as% K only:

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

How to read the Stochastic indicator

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

Anything greater than 80 reflects an overbought market condition. Below 20 reflects oversold market conditions. This indicator can only range from 0 to 100, regardless of how quickly the currency pair's price changes.

In the standard 14-session setup, an indicator above 80 indicates that the currency pair traded near the top of the trading range for the previous 14 sessions. When below 20 indicates trading near the lows of the trading range for the last 14 sessions.

A trend can go up or down continuously. However, stochastic may remain oversold or overbought for a long time.

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

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

Use Stochastic in trading

Trading at conditions of overbought, oversold

As explained, Stochastic is commonly used to trade in the condition of overbought, oversold or up and down divergence.

The example below is a trade in the direction of the trend. When an uptrend is established, how to trade when an oversold condition occurs

traded at stochastic oversold conditions

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

A possible trading strategy is when the% K line crosses the signal line from below. Level stop loss just below the previous low. It is also important to wait for additional confirmation signals such as candle pattern such as. Oscillating indicators are known to sometimes give false signals.

Divergence increases and decreases

Divergence is used to determine the top and bottom of a trend. Help decide when to enter and exit a position. In this regard, divergence is a leading indicator of future price action.

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

Watch now: What is the forex market? Is Forex a multi-level scam?

The example below is the case of bullish divergence on the daily chart. While prices perform consecutive lower levels, the stochastic indicator does not follow price movements.

Instead, it created higher levels. Indicators and prices diverge. Therefore, prices have changed the previous downtrend to start a new uptrend.

bullish divergence

Summary

So apart from the indicator trading tool like MA, MACD, Bollinger band, ... good elliott wave You know one more indicator stochastic quite awesome.

The combination of indicators is a must, since each indicator is relative, without absolute accuracy. A comparative analysis using different indicators should make an accurate judgment. From there you will trade more successfully and increase your technique. So, thanks!

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