How to use a stochastic indicator

A stochastic oscillator is a well-known momentum indicator. It resembles an RSI indicator and provides similar signals. Still, there are differences in calculations and sensitivity. 

The stochastic oscillator is used in numerous market conditions and is favored by investors and traders because its signals are very reliable. Keep reading to learn how to apply the indicator effectively. 

Stochastic indicator: fundamentals

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George Lane developed the stochastic oscillator in the 1950s. Interestingly, although in most tutorials, an overbought/oversold market condition is considered the main stochastic signal, the creator said that divergences are the first and maybe the most vital trading signal stochastic provides.  

Like all momentum oscillators, the indicator ranges between 0 and 100. It consists of two lines — %K and %D. %K is the main or fast line, and %D is a moving average of %K. It’s a so-called signal or slow line. Their interconnection is used to catch trading signals.

How to calculate %K and %D

%K = (the closing price – the lowest price for the period) / (the highest price for the period – the lowest price for the period) * 100

%D = simple moving average of %K

That is, the indicator compares an asset’s closing price to a range of its prices over a certain period. 

How to use the stochastic indicator

Like with any other indicator, the stochastic oscillator’s signals depend on its settings. The settings determine how many signs the indicator will provide. The standard settings are 5, 3, and 3. For some strategies, investors prefer 8, 3, 3 or 14, 3, 3. 

The lower the value, the larger the number of signals. If you use stochastic on low timeframes, you will be confused with numerous signals and market noise. Therefore, if you want to test low settings, you should use the indicator on higher timeframes. It’s a so-called fast stochastic indicator. 

How to start trading with indicators

To reduce the number of signals, use more extensive periods. The indicator with large periods will be effective on lower timeframes. If you use it for long periods, you risk missing trading signals. It’s a so-called slow stochastic indicator.

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How to read the stochastic indicator

As mentioned above, the indicator consists of two lines that range from 0 to 100. The key indicator levels are 20 and 80. The lines’ interconnection and their location provide various signals. There are three rules on how the stochastic indicator works.

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  • Overbought/oversold market. When the lines move above the 80 level, the asset is overbought and may decline soon. A common mistake of newbies is to sell the asset as soon as the indicator breaks above the 80 level. Stochastic may stay in the overbought zone for a long period. Therefore, the rule is to sell when it falls below 80. When the lines break below the 20 level, it’s an alarm that the asset is oversold. You can open a long position when the indicator rises above 20. 
  • Buy/sell signals. Another option to gain buy/sell signals is to consider the crossover of indicator and signal lines. When the indicator (%K) line crosses the signal (%D) line upside-down, it’s a sell signal. When the indicator line rises above the signal line, it’s a buy signal.  
  • Divergences. A divergence is one of the most reliable signals momentum indicators provide. When the price forms a lower low but stochastic rises, it’s a bullish divergence that signals an upward reversal. When the price forms higher highs while stochastic is falling, it’s a bearish divergence. You can expect the price to turn down soon. 

Tip: never open a position after you get a signal from one indicator. Confirm it with a sign of another indicator or a chart pattern. 

Final thoughts

The stochastic oscillator is the effective indicator that provides various signals and can be used in multiple market conditions. Still, it has a significant pitfall — it’s too sensitive. Therefore, it may give fake alerts. To use it efficiently, you should test different parameters on various timeframes and develop your own approach.

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