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The stochastic oscillator, or stoch or stochastics, is a trading indicator that follows the speed of trading momentum. This indicator is often used to determine overbought and oversold states.
As it is an oscillator, stoch fluctuates between 0 and 100:
- Under 20 = oversold
- Over 80 = overbought
The idea behind the stochastic oscillator is simple:
It works under the premise that changes in momentum precede changes in price action and trends.
Think of a car performing a U-turn. Before the U-turn (trend reversal) can take place, the car must slow down (momentum change).
The change in momentum can be integrated into your trading strategy to find possible reversal points in the market.
Stochastic oscillator parameters
The stochastic oscillator has two main parameters (lines), %K (the main line) and %D (the second line), and is calculated with the following formula: %K = 100(C - L𝑥)/(H𝑥 - L𝑥), where:
- C is the last closing price.
- L𝑥 is the low of the previous 𝑥 trading sessions.
- H𝑥 is the high of the previous 𝑥 trading sessions.
- %D is a three-day simple moving average (SMA) of %K.
Some charting platforms like TradingView also have a smoothing parameter, which implements a sort of buffer delay to reduce the noise of the indicator.
If you prefer to only use the %K line, setting %D and smoothing to 1 will effectively remove the SMA from the chart.
Stochastic oscillator trading strategies
Here are a few tips on how to implement the stochastic oscillator into your trading strategy:
Finding divergences between price and stoch
Divergence between price and an oscillator or other market indicator can often signal an imminent trend reversal in the near future.
This principle applies to the stochastic oscillator as well.
The image below shows a bearish divergence between price and stoch on the BTC/USD 1-hour chart.
As price makes a higher high from A to B, the stochastic oscillator indicates a lower high, which points to a loss of momentum as Bitcoin makes a new high.
Keep in mind that divergences can last for a long time. It’s typically best to wait until stoch drops below 80 before entering a short position.
In this case, the rapid stoch drop at C which coincides with a double top at USD4,300 presents a much better trade opportunity.
On the flipside, a bullish divergence happens when price makes a lower low while the stochastic oscillator prints a higher low.
The image below shows BTC’s recent decline to the USD3,200 range.
There are two examples of bullish divergences in this image. The divergence notated by A (orange arrow) fails to pop above 20 on the stochastic oscillator.
Similar to entering a short position before stoch drops below 80, entering a long position before stoch rebounds above 20 can often be risky.
In this situation, price ended up moving further downward to B.
The second bullish divergence (green arrow) shows stoch rebounding above 20, which indicates the presence of bullish momentum and the possibility of a trend reversal in the near future, and that’s exactly what happened in this case.
Trading the stochastic crossovers
Stochastic crossovers between the %K and %D lines can often result in excellent signals, especially when used with other trading indicators.
The image below shows four examples of stochastic crossovers.
In general, %K crossing over %D is bullish, while %D crossing over %K is bearish.
As you can see, price action following the bullish crossovers is positive, while price action following bearish crossovers is negative.
Using multiple stochastic oscillators
Many traders use two or three stochastic oscillators to gain insight into volume momentum at different time frames.
For example, a 5,3,3 stoch can be used for a near-timeframe reference, while something like a 21,14,14, which uses data from the past 21 trading periods, can be used for a more macro-level perspective of the market.
If you’re interested in exploring how the stochastic oscillator reacts to different number of trading periods, you could try setting up 5,3,3; 14, 3, 3;, and 21,14,14 to experiment with.
In summary, the stochastic oscillator is a momentum indicator and a useful tool for finding hidden strength and weakness in price action by identifying overbought and oversold conditions, as well as bearish and bullish divergences.
The key to success with the stochastic oscillator is finding the correct settings that work best with each asset and timeframe. Together with other indicators like RSI, MACD and candlestick patterns, the stochastic oscillator can help you develop a profitable trading strategy.
WRITTEN BYBrian Li
Trader, analyst, Liquid contributor. Editor of Decrypto.net.