The stochastic oscillator, created by G. Lane in 1950, takes shape starting from the mathematical model of the same name designed to study the trend of phenomena that follow random and probabilistic laws. This stochastic mathematical model is adapted to the market in order to better understand the price fluctuations and the changes it could undergo.
It notes that, during a bull market with an increase in prices, the closing value tends to approach the maximum of the price range of the analyzed period (price range). Similarly, during a bear market, closing prices tend to approach the minimum of the price range of the period under consideration.
The Stochastic is composed of two lines, the% K (called Fast Line) and the% D (called Slow Line), which move on an abscissa representing the period of time and an ordinate marked on a scale from 0 to 100 representing as a percentage (and not absolute) the relationship between the most recent closing price with respect to the maximum and minimum price in a given period of time.
The standard set-up of this oscillator is set to 14 Periods with the% K and% D moving averages set to 3 periods. The graphic arrangement provides on the axis of the ordinates 3 very important verification lines, placed at the absolute values of 80, 50 and 20.
Traditionally the Stochastic is considered overbought when it is above 80 and oversold when it is below 20, while the value set at 50 represents the median of the scale and often coincides with important support / resistance areas. Depending on the financial instrument studied, it is appropriate to check the quotas 70 for overbought and 30 for oversold if these, once reached, often confirm any inversions.
All modern trading platforms automatically provide this indicator as a chart study tool, but remember how you calculate the 2 lines:
The formula used to calculate the% K, is the following:
%K= 100 ((C – Low14) / (High14-Low14))
The obtained value of% K is on a percentage basis and measures the relationship of the closing price with respect to the identified price range.
The% D line is a 3-period moving average of the% K line, it is slower than the% K line.
If we find ourselves with values of% K higher than 80 we must interpret the closing value of the current session close to the maximum of the established price range, on the contrary, a value of% K lower than 20 indicates a closing price close to the minimum of the price established range.
The STOCASTIC indicator provides different types of signals:
The Stocasatic, as we have seen, is generally set to 14 periods with the oscillator line moving over time, marking the percentage of the change in price movements concerning the financial instrument studied, highlighting when there are limit situations of OVERBOUGHT or OVERSOLD.
Oversold levels typically occur below the 20 level, while overbought levels occur above the 80 value. their intersection. The level lines should cut the highest peaks and the lowest troughs generating a signal at their intersection.
Although it represents an important signal, reaching the overbought or oversold areas is not synonymous with a change in trend; in fact, during strong trends, the Stochastic could remain in the overbought or oversold areas for long periods and continue to retest the same areas frequently generating a continuous price increase even if overbought, generating false signals.
Here we can see an example of achieving overbought, leaving the overbought zone and again reaching overbought levels. All these signals would have led to exit from the position preventing the correct growth trend from following.
This also represents an important signal for establishing entry and exit positions.
When the% K line (fast line) crosses the% D line (Slow Line) from the bottom upwards, a buy signal is generated. Conversely, when the% K line crosses the% D line from top to bottom, a sell signal is generated.
The valence of the signal will be even more important if this occurs in the overbought or oversold areas. However, it remains not enough to have a trend reversal guarantee.
This signal is the only one that ascertains the reversal of the trend; let’s not forget that the stochastic follows a trend of the price variation, substantially determining a speed of construction of the lines, but not a precise direction. In practice, the intensity of the movement is known, but not its directionality. This can be obtained only by looking at the price and its movements on the chart.
It is therefore possible to draw simple trend lines on the Stochastic lines in order to identify important changes in the current trend by identifying existing divergences between the Stochastic lines and the price lines on the chart.
Spotting a divergence between Stochastic and price action becomes an even stronger signal when it confirms the signals of crossing between the% K and% D lines.
We see the divergences when the price movement is not confirmed by the indicator, which continues its run in the opposite direction.
Specifically, we are talking about a bullish divergence when the% D line of the indicator is below the 20 level and draws two rising lows on the chart as opposed to prices that continue to fall.
Differently, a bearish divergence is identified when the indicator marks decreasing highs above the 80 line while prices continue to rise. When these divergences occur, a possible buy or sell signal is given by the crossing of the% K line with the% D line.
Due to its constructive logic, the Stochastic is only suitable for providing overbought and oversold signals and for identifying possible divergences by comparing the trend of the indicator with the price chart.
It is therefore a very useful tool for identifying trends and managing the timing of market entries and exits, but to be combined with the graphical analysis of the chart or with other tools such as the Bollinger Bands to research take profit levels.
Therefore, we cannot use the Stochastic as a price target but only as a support to the graphical analysis.