Stochastic Indicator

The Stochastic Indicator

George Lane was the originator of the stochastic indicator in the 1970's. Lane observed that as prices rises in an up trend, closing prices tend to be closer to the upper end of candles/bars and in a down trend closing prices tend to be nearer the lower end of candles/bars.

Lane developed stochastics to recognise the relationship between the closing price and the high and low of a bar. The Stochastic indicator is typically used to identify overbought and oversold conditions. The indicator consists of two lines: % K fast and %D slow. These two lines fluctuate in a vertical range between 0 and 100. Readings above 80 are considered overbought and readings below 20 are considered oversold.

A Stochastic is another indicator that helps us to determine where a trend might be ending.

How to Trade with Stochastics

Because Stochastics tell us when the market is overbought or oversold we can use them to identify trading opportunities . When the stochastic lines are above 80 (the black dotted line in the chart below), then it means the market is overbought. When the stochastic lines are below 20 (the Black dotted line), then it means that the market is oversold. Generally, we buy when the market is oversold, and we sell when the market is overbought.

As we can see from the above chart there were at least 3 crosses of the stochastic, (Blue high lights) one to sell and 2 buy signals. The sell signal produced almost a 200 pip profit on the trade whilst the 1st buy signal failed and the second produced only a small profit.

However just because the the market is overbought or oversold is not reason enough to enter a trade. We have to wait for the faster red dotted line to cross through slower blue line and both lines must move back between the 20 and 80 zone of the Stochastic.

In strong trending trades the Stochastic can stay overbought or oversold for some time whilst

price continues in a single direction. (See next chart.)

On this chart (setting 8, 3, 3) we can see that the majority of the down move occurred whilst the market was in an oversold condition. The market stayed this way for almost 3 days before we got the buy signal.

As with all indicators the settings can be changed. We can weaken or strengthen the signal by altering the settings to make it more/less sensitive to price change. On the next chart we have strengthened the signal or made it less sensitive to change by altering the settings to 13, 8 ,5,

As we can see from this chart which is the same as the previous one, by altering the settings we avoid going long in the market as the stochastic lines do not cross back up between the 20 and 80 zone.

As with the MACD Indicator stochastics are also useful for identifying divergence which we will look at later.

Like most indicators, stochastics are best traded with other indicators to confirm entries.