How to trade using Stochastic indicator

Stochastic indicator is a momentum indicator that indicates overbought and oversold conditions on the scale of 0 – 100%. It was developed by George Lane in 1950s. It compares currency closing  prices over a given period and is also used to determine whether the trend might be ending.

Stochastic indicator bases on an assumption that closing prices tend to concentrate in the higher parts of the period range in a strong uptrend and near the extreme of low of the period range for a downtrend.

The stochastic calculator has two lines, %K and %D used to indicate the overbought and oversold conditions on the chart plotted on the horizontal axis and 0 –100% on the vertical axis for a given period.

The default setting for stochastic indicator is 14 periods, it can be hours days weeks or months.

When the readings are above 80%, %K line crosses over %D line as both lines are pointing down, it indicates a sell signal.

If the two lines cross and are both pointing up at a reading below 20%, that gives a buy signal.

Stochastic indicators can be used to determine the probable reversal point by taking a look at the divergence between the market price and the stochastic indicator being used.

It diverges when the market price makes a lower low from the previous low but the underlying stochastic makes a higher low(bullish divergence). This indicates a false low as a result of less down side momentum. This signals a price reversal.

A bearish divergence forms when the market price forms higher highs but the stochastic forms lower highs. Shows a less upside momentum and a false high. It signals price reversal.

How to trade using stochastic?

 Stochastic bases  on an assumption that during a strong uptrend, prices tend to close near extreme high and during a strong down trend prices close near extreme lows hence indicating the overbought and oversold areas on a chart.

The stochastic is scaled for 0 to 100%. When the line is above 80%, the line show that the market is overbought. Below 20%, it is oversold. Basing on that we can determine where the market is going next. Buy when the market is over sold when the indicator reads below 20%  and sell when the market is over bought when the reading is as high above 80% .

Let’s now look at the chart below;

From the chart above, as the indicator fluctuates, when it reads 80 and above and the %K line crosses over %D line as both lines are pointing down, it gives sell signals as indicated above. 

When the scale reads 20% and below and the %K line crosses over %D line as both lines are pointing up,it gives buy signals; good time to buy.

Stochastic like any other indicator works better when combined with other indicators. We will discuss the details on how to trade multiple indicators in next sessions.

Trading Divergences using Stochastic

The stochastic indicator can also be traded by looking at the price movements in relation to stochastic movements identifying divergence points. By doing this you will be able to identify the possible reversal point in the trend.

Like discussed in the previous sessions, Divergence occurs when the market price makes a lower low from the previous low but the underlying indicator, in this case stochastic, makes a higher low(bullish divergence). This indicates a false low as a result of less down side momentum. This signals a price reversal.

A bearish divergence forms when the market price forms higher highs but the stochastic forms lower highs. Shows a less upside momentum and a false high. It signals price reversal.

Let’s look at the chart below,

In the above example, we have a bullish divergence, the price makes a lower low and the Stochastic makes a higher low. This give a signal for a buy trade.

 

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