Stochastic Oscillator Overview, How to Calculate, and Uses

stochastic indicator explained

He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem. Trading and investing on the financial markets carries a significant risk of loss. The materials available on this website do not constitute investment advice. If you make a decision to trade or invest, based on the information from this website, you will be doing it at your own risk.

Because the market was overbought for such a long period of time, a reversal was bound to happen. The Stochastic technical indicator tells us when the market is overbought or oversold. When the asset is oversold, the stochastic is below 20, while the RSI is below 30. When the asset is overbought, the stochastic is above 80, while the RSI is above 70. It’s worth remembering these rules to read the signals correctly. You don’t need to calculate the indicator manually as it’s automatically implemented and calculated on trading platforms – for instance, on the TickTrader platform.

Pros & Cons of the Stochastic Indicator

According to George Lane, the Stochastics indicator is to be used with cycles, Elliott Wave Theory and Fibonacci retracement for timing. In low margin, calendar futures spreads, one might use Wilders parabolic as a trailing stop after a stochastics entry. A centerpiece of his teaching is the divergence and convergence of trendlines drawn on stochastics, as diverging/converging to trendlines drawn on price cycles. I’m not going to waste my time or yours analyzing each trade signal from the crosses above and below 50 in the chart.

  • It is also considered a very efficient technical analysis tool that combines the aforementioned tool with momentum, which provides smoother signals and is less dependent on market noise.
  • However, most traders don’t rely on the stochastic oscillator alone.
  • To implement the technical indicator in the chart, press “Indicators” and choose “Stochastic Oscillator” from the dropdown list.
  • When analyzing the indicator’s behavior in overbought or oversold zones, it’s worth considering the reversal’s formation in order to spot a potential buy or sell signal.
  • We will cover its structure, signals, and compatibility with other instruments.
  • The SMI, on the other hand, shows the closing momentum relative to the median high or low range for a particular period.

The %K and %D lines move relatively closely to one another, with the %K line leading slightly. Karl Montevirgen is a professional freelance writer who specializes in the fields of finance, cryptomarkets, content strategy, and the arts. Karl works with several organizations in the equities, futures, physical metals, and blockchain industries. He holds FINRA Series 3 and Series 34 licenses in addition to a dual MFA in critical studies/writing and music composition from the California Institute of the Arts.

Commodity Channel Index (CCI) Indicator

A stochastic oscillator or stochastic indicator is a technical analysis tool that helps traders determine overbought and oversold market conditions and forecast future price directions. The stochastic is often compared with relative strength indicator (RSI) as both tools are oscillators that provide similar signals. The Stochastic Oscillator is a momentum indicator that shows the speed and momentum of price movement.

A stop-loss is placed slightly below the minimum (the red line). First, we add three exponential moving averages with periods of 50-, 100-, and 200-bars. The most valuable signal is the third one, which indicates a trend reversal, in some points protects the trader from losing money rapidly. LiteFinance gives you the chance to experiment with a free demo account, but also provides the full version of the indicator.

Stochastic overbought/oversold strategy

If you’d like a primer on how to trade commodities in general, please see our introduction to commodity trading here. Stochastic Slow is presented below in the chart of the E-mini Russell 2000 Futures contract. Above 80 is generally considered overbought and below 20 is considered oversold. Miguel worked for major financial institutions such as Banco Santander, and Banco Central-Hispano.

stochastic indicator explained

However, the stochastic momentum index (SMI) shows the closing momentum relative to the median high or low range for a particular time period. Readings above 80 signal that the asset is trading near the top of its stochastic indicator explained high-low range. Conversely, readings below 20 indicate that the asset is trading near the bottom of its high-low range. Readings above 50 suggest the asset is trading among the upper section of the trading range.

After the reversal, there is an intensive downward movement showing a potential sell signal, offering to the trader the chance to understand how spread bets. However, when compared to the Stochastic RSI, the standard RSI is a relatively slow-moving indicator that produces a small number of trading signals. The application of the Stochastic Oscillator formula to the regular RSI allowed the creation of the StochRSI as an indicator with increased sensitivity. Consequently, the number of signals it produces is much higher, giving traders more opportunities to identify market trends and potential buying or selling points. Rather than using readings above 80 as the demarcation line, they instead only interpret readings above 85 as indicating overbought conditions.

What are the rules for stochastic trading?

Trading Stochastic Indicator Signals

To place a buy order in a support area, the stochastic reading must be below 20, and the %K line must cross the %D line upwards. Likewise, to place a sell order in a resistance area, the stochastic reading must be above 80, and the %K line must cross the %D line downwards.

The fast stochastic line is the 0%K line, and the slow stochastic line is the %D line. When the %K line intersects the %D line and goes above it, this is a bullish scenario. Conversely, the %K line crossing from above to below the %D stochastic line gives a bearish sell signal. As you have seen, the stochastic is a technical analysis momentum indicator that can help you identify retracements and reversals so you can jump in on trades earlier. This stochastic 50-level crossover is viewed as a strong movement to the upside and interpreted as a buy signal. By contrast, when the %K line crosses below the 50 level, it’s interpreted as weakness in price movement, which signals that it’s time to sell.

Stochastic Oscillator Oversold Upturn

The stochastic oscillator, also known as stochastic indicator, is a popular trading indicator​ that is useful for predicting trend reversals. It also focuses on price momentum and can be used to identify overbought and oversold levels in shares, indices, currencies and many other investment assets. The stochastic indicator is classified as an oscillator, a term used in technical analysis to describe a tool that creates bands around some mean level. The idea is that price action will tend to be bound by the bands and revert to the mean over time.

stochastic indicator explained

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