The stochastic indicator analyzes price momentum by examining price movements over a specific time period. This stochastic oscillator is a momentum-based indicator used in technical analysis.
When it is combined with other tools like the Relative Strength Index (RSI) or the Moving Average Convergence Divergence (MACD), it enhances the success rate of trading strategies.
What Is the Stochastic Indicator?
The stochastic indicator identifies price momentum by analyzing past market data such as closing prices and price range within a specific period (typically 14 days).
This indicator displays the data in a range between 0 and 100. If it moves above the 80 level, it indicates overbought conditions. If it moves below the 20 level, it indicates oversold conditions.
Pros and Cons of the Stochastic Indicator
The stochastic indicator is highly sensitive and generates relatively more signals than other momentum indicators.
However, these signals alone are not sufficient for entering a trade and should be used in conjunction with other technical analysis concepts such as classical chart patterns.
Pros | Cons |
High sensitivity and frequent signals | Relatively high number of false signals |
Simple signal structure | Delay in signal issuance |
Applicable to all financial markets | Requires complementary confirmations |
Easy and quick to learn | Needs setting adjustments in different conditions |
Components of the Stochastic Indicator
This indicator consists of two lines: %K and %D. The crossover of these two lines is considered a signal for identifying the next possible price move.
- %K Line: Calculates the ratio of the current price to the highest and lowest prices over a defined period;
- %D Line: A simple moving average (SMA) of the %K line, which helps filter out noise in the indicator.
How the Stochastic Oscillator Works?
The stochastic indicator uses two lines fast (%K) and slow (%D) to reflect price momentum.
When the fast line (%K) crosses below the slow line (%D), it generates a sell signal. When the fast line crosses above the slow line from below, it generates a buy signal.
Another important function of this indicator is the detection of overbought and oversold levels. The stochastic oscillator’s display is divided into three zones using the 20 and 80 lines:
- If the indicator lines enter the area above 80, it signals overbought, which may lead to a downward trend reversal;
- If the lines drop below 20, it indicates oversold conditions and the possibility of a bullish reversal.
Stochastic Indicator Formula
In its default settings, the stochastic indicator formula is calculated based on:
- C = Current closing price
- H14 = Highest price over the last 14 periods
- L14 = Lowest price over the last 14 periods
Formula:
Identifying Divergence Using the Stochastic Indicator
The stochastic oscillator can identify both regular divergence and hidden divergence.
Regular Divergence in the Stochastic Indicator
Regular divergence helps detect changes in trend direction, whether bullish or bearish. In uptrends, traders examine highs; in downtrends, they assess lows:
- In an uptrend, if the stochastic forms lower highs (LH) while the price chart shows higher highs (HH), a bearish regular divergence is forming;
- In a downtrend, if the stochastic forms higher lows (HL) while the price shows lower lows (LL), a bullish regular divergence is present.
Hidden Divergence in the Stochastic Indicator
In hidden divergence, the likelihood of the continuation of the existing trend is analyzed. If confirmed, the price trend is expected to persist.
- In an uptrend, if the price forms higher lows but the stochastic shows lower lows, a bullish hidden divergence is confirmed;
- In a downtrend, if the price forms lower highs while the stochastic displays higher highs, a bearish hidden divergence is formed.
Trading Strategy Using the Stochastic Oscillator and Candlestick Patterns
This trading strategy combines the stochastic indicator with candlestick patterns, filtering signals to improve accuracy and success rate.
#1 Stochastic Lines Enter the Extreme Zone
The first step is for the stochastic lines to enter the overbought or oversold areas:
- If the lines enter the overbought area, Look for a sell opportunity;
- If lines enter the oversold area, Look for a buy opportunity.
#2 Formation of Candlestick Pattern
Once the price enters an extreme zone, a candlestick reversal pattern such as the Hammer should form on the price chart and be confirmed by the next candle.
Note: Entering a trade before the confirmation candle may reduce the success rate of this strategy.
#3 Trade Entry
After the confirmation of the reversal candlestick pattern by the next candle, a trade signal is generated in the direction of the candlestick confirmation.
- The stop-loss order should be placed above the reversal candlestick (in case of a sell trade) or below it (in case of a buy trade);
- The take-profit level should be placed at the next key level, such as a support or resistance area.
Combining the Stochastic Oscillator with Other Technical Indicators
The stochastic indicator is highly compatible with other technical tools. Combining this stochastic oscillator with indicators like the Moving Average (MA), Relative Strength Index (RSI), or MACD can improve the effectiveness of your trading analysis.
Stochastic Indicator + Moving Average (MA)
A long-period moving average (e.g., 200-period) can act as dynamic support or resistance.
When the stochastic indicator issues a bullish signal and the price is positioned above the moving average, the signal becomes more reliable.
Stochastic Indicator + Relative Strength Index (RSI)
Using the RSI alongside the stochastic oscillator helps traders enter positions faster with more confirmation.
For instance, if a divergence appears on the stochastic but the lines haven’t yet reached overbought or oversold zones, traders can consult the RSI for confirmation.
If the RSI also indicates overbought or oversold conditions, the trader may proceed with the trade in the direction of the divergence.
Stochastic Indicator + MACD
When divergences appear on both the stochastic indicator and the MACD histogram, traders can use this to filter out false signals more effectively.
For example, if a divergence is identified on the stochastic oscillator but is not confirmed on the MACD histogram, the validity of the stochastic signal is reduced therefore, that signal should be ignored or treated with caution.
Conclusion
The stochastic oscillator is a momentum-based indicator that compares the current closing price to the high and low prices over a specified period (typically 14 days).
It consists of two lines, %K and %D, that oscillate between 0 and 100. The levels above 80 indicate overbought conditions, and the levels below 20 indicate oversold conditions.
The indicator can be combined with candlestick patterns, as well as other technical indicators like RSI, MACD, and Moving Averages, to improve signal confirmation and increase the success rate of trading strategies.
