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Learn How To Use The Stochastic Indicator Step By Step

The following article is not meant to discuss whether the Stochastic indicator is good or bad; the goal is to show you what it takes to understand the tools you are using for your trading. If you are like most traders, you just throw an indicator on your chart and follow some random advice from the internet. Big mistake. After reading the following article you will see that everything you thought you knew about the Stochastic indicator was wrong. This will be not only true for the Stochastic indicator, but for the majority of trading indicators, tools and even price action.

The unprofitable trader picks an indicator and asks other people how to use it. The professional trader researches and finds out by himself what his trading tools are telling him.

 

What is the Stochastic indicator?

The general thought is that when the Stochastic is going up, price goes up and when the indicator goes down, price goes down. Wrong! The main function of the Stochastic indicator is to provide information about momentum and the strength of a trend. This means that the Stochastic indicator tells you how fast/strong price went up or down.

“Stochastics measures the momentum of price. If you visualize a rocket going up in the air – before it can turn down, it must slow down. Momentum always changes direction before price.” – George Lane, the developer of the Stochastic indicator

 

What is momentum and how does the Stochastic indicator measure it?

  • The rate of acceleration of the price of a security. – Investopedia
  • The “speed” of a price movement

The stochastic indicator analyzes a price range over a specific time period; typical settings for the Stochastic are 5 or 14 periods. This means that the Stochastic indicator takes the absolute high and the absolute low of that period and compares it to the closing price. We will see how this works with the following two examples.

 

What does a high Stochastic number mean?

stoch2When your Stochastic is at a high value, it means that price closed near the top of the range over a certain time period. As you can see with the following graphic, price closed near the top of the range of the previous 5 candles; the interpretation of the Stochastic would be that momentum/speed is high and it is likely that price will push higher because the force behind the move in price is strong.

How a high Stochastic is calculated
The lowest low of the 5 candles: $ 60
The highest high of the 5 candles: $ 100
The close of the last candle: $95
The value of the Stochastic indicator: [(95 – 60 ) / (100 – 60)] * 100 = 88%

You can see that because price closed very close ($95) to the highest point of the range ($100), the Stochastic value is high, indicating a strong uptrend.

 

 

 

 

 

What does a low Stochastic number mean?

Stoch1Conversely, a low Stochastic value indicates that the momentum to the downside is strong. The screenshot below shows that price in the marked range closed near the bottom of the range and, therefore, resulted in a Stochastic value below 20, near the bottom.

How a high Stochastic is calculated
The lowest low of the 5 candles: $ 50
The highest high of the 5 candles: $ 80
The close of the last candle: $55
The value of the Stochastic indicator: [(55 – 50 ) / (80 – 50)] * 100 = 17%

You can see that because price closed very close ($55) to the lowest point of the range ($50), the Stochastic value is low indicating a strong downtrend.

 

 

 

 

What if the trend is really strong?

How often have you seen a Stochastic staying below 20 for a long time and wondered why it is not going up since it is ‘oversold’? It is a general misconception that the indicator shows ‘oversold’ or ‘overbought’ prices.

The Stochastic indicator does not show oversold or overbought prices. It shows momentum.

When the Stochastic is above 80 it means that the trend is strong and not, that it is overbought. As we saw earlier, a high Stochastic value signals a trend with strong momentum and the belief that a Stochastic shows when prices are oversold or overbought is just plain wrong and a proof that people do not understand the indicator itself. A trend where the Stochastic stays above 80 for a long time signals that momentum is high and not that you should get ready to short the market.

The image below shows the behavior of the Stochastic within a long uptrend and a downtrend. In both cases, the Stochastic entered “overbought” (above 80), “oversold” (below 20) and stayed there for quite some time, while the trends kept on going. Again, the belief that the Stochastic shows oversold/overbought is wrong. A high Stochastic value shows that the trend has strong momentum and NOT that it is overbought.

 

How to use the Stochastic indicatorclick to enlarge

 

 

Do you really need a Stochastic indicator?

This article is not about whether a Stochastic indicator is good or bad. In fact, it does not matter whether you are using price action alone, indicators, or a combination of both, the only thing that determines whether you will make money or lose it is how you apply what you know to your charts. However, if you pick your trading arsenal, it is important that you know exactly what it is you are analyzing and how to overcome the shortcomings.

 

What the Stochastic does:

– It measures momentum and speed of price over a specific period
– A high value indicates a strong uptrend with lots of momentum
– A low value indicates a strong downtrend

 

What the Stochastic cannot do:

– It cannot tell you whether a trend is going to continue. The Stochastic is backward-looking
– The general belief that the Stochastic can show overbought/oversold is plain wrong and a sign that people do not understand the indicator. A Stochastic value of above 80 just signals a strong uptrend and a Stochastic below 20 indicates a downtrend with strong momentum.

 

Recap: How to use the Stochastic indicator

You might not need the Stochastic indicator when you are able to read the momentum of your charts by looking at the candles, but if the Stochastic is the tool of your choice, it certainly does not hurt to have it on your charts (this goes without a judgment whether the Stochastic is useful or not).

More importantly, this article is meant to make you realize how little you might know about the tools you use for your trading. Additionally, there is a lot of wrong knowledge being shared among traders and even widely used tools such as the Stochastic indicator is often misinterpreted by the majority of traders. Do not blindly believe what other people tell you, do your own research and build your trading knowledge.

 

What do you want to do next?

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23 comments

  1. Interesting. I honestly didn’t know that this is what the stochastics are doing although I have been using them from time to time. Thats an eye opener. thx

    jos

  2. Thanks! I never really wondered how the indicators on my charts are actually being computed but you have a valid point. I also totally misunderstood the Stochastics. I wish you could do more of these with different indicators…

  3. oh wow, I never knew that the Stochastic is being calculated this way. I agree with the poster before, please more articles like that one for different indicators…

  4. Interesting! It’s nice that you are providing some info on how the indicators are actually calculated. It’s a great help so that we can understand how they really work! 😀

    Just a silly question, though. How do we define “overbought” and “oversold” anyway? Because from how I understand it, prices go up because demand is greater than supply i.e. there are more buyers. Doesn’t this correspond to an “overbought” condition?

    • I just use the regular definition for overbought/oversold. But, as you will notice, I am very critical when it comes to overbought/oversold because I believe that most traders are using it wrong.

      I agree overbought should be seen more as an indication of a strong trend rather than a reversal signal, which is what most traders make out of it.

  5. Well explained and thanks a million

  6. great article but i have a very silly question, how do you come to use $100 at high and $95 at close where do those figures come from?

  7. You share great content in easy to understand format. Thanks a lot for your articles! They are really helping in understanding clear concepts.

  8. Jayprakash Pathak

    very technical …..bounced over head .

  9. Hi Admni,please what’s the significants of the stochastics crossing. Kindly explain. Thanks.

  10. what to do or what does that mean stochastic is at 100 ?? thanx

  11. When stochs (i use 14 3 3) are over 80 and spotting a reversal in candles, only then i get ready to short the markt.
    The reverse is also true… low stochs and a reversal in candles let me think about long.
    Then you get into the situation that crossings of the stochs happen in ”mid” air.
    Then it is worthy to stay with the trend.

  12. it says right on the tools, overbought, oversold, hmmmmm

    • Once you look at the actual formula and look at the calculations, you will understand that the only thing it calculates is strength and not turning points.

      Rolf

  13. For a long time looking for the correct description of the stochastic and generally many indicators. Very nice and useful site, thanks for the good work for the benefit of all!

  14. Have just read your article; THANK YOU ! Been Using the indicator the wrong way; OVERSOLD and OVERBOUGHT. Looking forward to more articles.

  15. what setting would you recommend for this? thanks

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