The stochastic oscillator is a momentum indicator that is comparing the closing price of an asset to the range of its prices over a certain period of time.
The "Stochastic View" is a term used by mathematicians whereby one views nature through the lens of probability theory.
The premises of this oscillator is that when the market is in an uptrend, the price closes nearer to the high of that candle's price action; when the market is in a downtrend, the price close nearer to the low.
The stochastic oscillator indicates the speed or rate of acceleration for a particular asset. Therefore, in a fast moving, volatile market the stochastic indicator shows steep angled, sharp movements.
The indicator is made up of two lines; the %K line and the %D line. I will not include the formulas for these lines as almost all charting software will carry these out automatically. The main thing to understand is that both of these lines are essentially moving averages. %K line represents the current market rate of the asset being charted. %D is the 3-period moving average of %K (the average of the previous 3 %K values). Therefore, %D is the slower of the two moving averages. Stochastic signals can be treated in a similar way as normal chart moving averages (see moving averages analysis) when the %K crosses through the %D and vice versa. The suggested value for %K is 14 and for %D it is 3.
Stochastic Use Cases
Similarly to the RSI indicator, stochastic is range bound (0-100). This means it can be used to identify overbought and oversold conditions in the market whereby, a value over 80 indicates overbought conditions and a value below 20 indicates oversold. Stochastic attempts to predict reversals in the market by comparing the closing price to the price range. During a trend, before a reversal occurs, the price tends to close towards the extremes of a price range. As momentum begins to slow down before the reversal, price starts to edge away from these price extremes (might be indicated by indecision candles) causing the stochastic indicator to reverse at the peak in price action. As mentioned previously, a signal might come in the form of the %K line crossing the %D line. As these crosses occur quite frequently, it would be more accurate to wait for the crosses to occur within the oversold/overbought areas before considering potential for a trade.
For example, during a volatile bullish trend where price is aggressively pushing higher the stochastic will also be moving higher at a steep angle. Once the stochastic reaches a value >80 a trader might begin to look for an opportunity to short/sell the market therefore, catching the reversal of the current trend. As price gets higher the momentum of this push up is likely to decrease. The closes of the candles are no longer towards the top of their ranges (i.e. indecision candles start to form). Because of this change in momentum the stochastic indicator starts to reverse, moving lower. In doing so, the %K line will cross below the %D line at, or before, the final price extreme (high) predicting a reversal before it happens.
Another way to utilise this indicator is to look for divergence. Divergence can be identified in most oscillators, most commonly RSI (see Relative Strength Index). Divergence occurs when price makes a higher high/lower low however, the oscillator completes the opposite pattern i.e. price forms higher highs but the corresponding stochastic shows lower highs. Divergence can be used to indicate a slow in momentum which, in turn, can be used to determine a reversal in trend. For example, although price is making higher highs, if the stochastic is show lower highs this indicates that price has not moved higher with the same speed or enthusiasm as it has previously.
Like any other indicator, the stochastic oscillator can be a powerful tool in every trader's toolbox. However, it should not be used as a standalone system but used in conjunction with other systems in order to improve trading success.
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