I am always astonished that many traders don’t really understand the indicators they are using. Or, even worse, many traders use their indicators in a wrong way because they have never taken the time to look into it. In this article, I will help you understand the STOCHASTIC indicator in the right way and I will show you what it does and how you can use it in your trading.
What is the Stochastic indicator?
The STOCHASTIC indicator shows us information about momentum and trend strength. As we will see shortly, the indicator analyses price movements and tells us how fast and how strong the price moves.
This is a quote from George Lane, the inventor of the STOCHASTIC indicator:
“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?
Before we get into using the Stochastic, we should be clear about what momentum actually is.
Investopedia defines momentum as “The rate of acceleration of the price of a security.” via Investopedia
I am always a fan of going into how an indicator analyzes price and without getting too deep into the mathematics, this is how the indicator analyzes price:
The stochastic indicator analyzes a price range over a specific time period or price candles; typical settings for the Stochastic are 5 or 14 periods/price candles. 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 and I have chosen a 5 period Stochastic which means that the Stochastic only looks at the last 5 candlesticks.
Example 1: A high Stochastic number
When your Stochastic is at a high value, it means that price closed near the top of the range over a certain time period or number of price candles.
The graphic shows that the low was at $60, the high at $100 (range of $40) and price closed almost at the very top at $95. The Stochastic shows 88% which means that price only closed 12% (100% – 88%) from the absolute top.
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, the high Stochastic shows us that price was very strong over the 5 candle period and that the recent candles are pushing higher.
Example 2: A low Stochastic number
Conversely, a low Stochastic value indicates that the momentum to the downside is strong. In the graphic we can see that price only closed $5 above the low of the range at $50.
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%
The Stochastic of 17% means that price closed only 17% above the low of the range and, thus, the downside momentum is very strong.
Overbought vs Oversold
The misinterpretation of overbought and oversold is one of biggest problems and faults in trading. We’ll now take a look at those expressions and learn why there is nothing like overbought or oversold.
The Stochastic indicator does not show oversold or overbought prices. It shows momentum.
Generally, traders would say that a Stochastic over 80 means that the price is overbought and when the Stochastic is below 20, the price is considered oversold. And what traders then mean is that an oversold market has a high chance of going down and vice versa. This is wrong and very dangerous!
As we have seen above, when the Stochastic is above 80 it means that the trend is strong and not, that it is overbought and likely to reverse. A high Stochastic means that the price is able to close near the top and it keeps pushing higher. 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 and you will quickly run into problems when you trade this way. A high Stochastic value shows that the trend has strong momentum and NOT that it is overbought.
The Stochastic signals
Finally, I want to provide the most common signals and ways how traders are using the Stochastic indicator:
- Breakout trading: When you see that the Stochastic is suddenly accelerating into one direction and the two Stochastic bands are widening, then it can signal the start of a new trend. If you can also spot a breakout out of sideways range, even better.
- Trend following: As long as the Stochastic keeps crossed in one direction, it shows that the trend is still valid.
- Strong trends: When the Stochastic is in the oversold/overbought area, don’t fight the trend but try to hold on to your trades and stick with the trend.
- Trend reversals: When the Stochastic is changing the direction and leaves the overbought/oversold areas, it can foreshadow a reversal. As we’ll see, we can also combine the Stochastic with a moving average or trendlines nicely.
- Important: when we look for a bullish reversal, we need to see the green Stochastic line to get above the red one and leave the overbought-oversold area.
- Divergences: As with every momentum indicator, divergences can also be a very important signal here to show potential trend reversals, or at least the end of a trend.
Combining the Stochastic with other tools
As with any other trading concept or tool, you should not use the Stochastic indicator by itself. To receive meaningful signals and improve the quality of your trades, you can combine the Stochastic indicator with those 3 tools:
- Moving averages: Moving averages can be a great addition here and they act as filters for your signals. Always trade in the direction of your moving averages and as long as price is above the moving average, only look for longs – and vice versa.
- Price formations: As breakout or reversal trader, you should look for wedges, triangles and rectangles. When price breaks such a formation with an accelerating Stochastic, it can potentially signal a successful breakout.
- Trendline: Especially Stochastic divergence or Stochastic reversal can be traded nicely with trendlines. You need to find an established trend with a valid trendline and then wait for price to break it with the confirmation of your Stochastic.
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.
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