# How to use Stochastics Indicator in Trading

By | January 30, 2016 1:54 pm

Technical analysis is a science of forecasting the price of stock/index/commodities based on price and volumes data.

Technical analysis is practiced in two main categories

• Charts Patterns
• Technical Indicators

Chart Patterns — A chart pattern is a pattern that is formed within a chart when prices are graphed. In stock and commodity markets trading, chart pattern studies play a large role during technical analysis. When data is plotted there is usually a pattern which naturally occurs and repeats over a period of time.

Technical Indicators — Technical Indicator is a result of mathematical calculations based on indications of price and/or volume. The values obtained are used to forecast probable price moves and trend in a particular stock/index. Indicators help you assess the market for its momentum, direction, etc.

Technical Indicators are of two main types

• Lagging Indicator

Leading Indicator — They give the trend reversal signals in advance based on mathematical calculations. RSI and Stochastic are two most important technical indicators. These works best in trading market or a period of sideways trading ranges.

Lagging Indicator – These follows price movements and has less predictive qualities. The most well-known lagging indicator is the MACD. These works best in trending market.

STOCHASTICS: An Introduction

The Stochastic indicator is a momentum indicator which gives you reversal signal in price momentum near important turning points allowing you enter the market with great accuracy for bigger profits.

Stochastic was developed by George C. Lane in the late 1950s, is a momentum indicator which gives you reversal signal in price momentum near important turning points allowing you enter the market with great accuracy for bigger profits.

According to an interview with Lane, the Stochastic Oscillator “doesn’t follow price, it doesn’t follow volume or anything like that. It follows the speed or the momentum of price. As a rule, the momentum changes direction before price.”

Calculation

The stochastic oscillator is calculated as a percentage of a security’s closing price to its price range over a given time period.

This indicator is calculated with the following formula:

%K = 100[(C – L14)/(H14 – L14)]

C = the last traded price at closing.
H14 = the highest traded price in last 14-day sessions.

%D = 3-period moving average of %K. It acts as a trigger line

The default setting for the Stochastic Oscillator is 14 periods, which can on Hourly,Daily,Weekly and monthly charts.

Let’s illustrate the calculation with Example of Dell Inc.

As shown in above Dell Inc. daily chart for a period of 14 trading days 08/12/2009 to 28/12/2009 as shown in Rectangle.

The High was 14.81\$ and Low was 12.74\$. Dell Inc. closed on 13.11\$ after hitting a low of 12.74\$ on 9/12/2009.

Let’s put the above data in formulae:

%K = 100[(13.11 – 12.74)/(14.81 – 12.74)] =17.81 (Oversold range)

%K (Blue Line) in above chart is at 17.81 which is lower range in stochastic.

To calculate the Upper range of Stochastic we will the closing value on 28/12/2009 which is 14.6\$

Putting the values in formulae we get :

%K = 100[(14.6 – 12.74)/(14.81 – 12.74)] =89.85 (Overbought range)

Low readings (below 20) indicate that price is near its low for the given time period. High readings (above 80) indicate that price is near its high for the given time period.

TYEPS OF STOCHASTICS: FAST, SLOW OR FULL

The Stochastic can be further categorized into 3 types

1. Fast Stochastic Oscillator
2. Slow Stochastic Oscillator
3. Full Stochastic Oscillator

1. Fast Stochastic Oscillator

The Fast Stochastic Oscillator is based on original formulas for %K and %D. As per Lane %D divergence is the “only signal which will cause you to buy or sell”.

Fast Stochastic plots the location of the current price in relation to the range of a certain number of prior bars (dependent upon user-input, usually 14-periods).

The inputs to Stochastic Fast are as follows:

Fast %K:   [(Close – Low) / (High – Low)] x 100

Fast % D: 3-period SMA of Fast %K

SLOW STOCHASTIC OSCILLATOR

The Slow Stochastic Oscillator smoothes %K with a 3-day SMA, which is exactly what %D is in the Fast Stochastic Oscillator.

Calculation for Slow Stochastic Oscillator:

Slow %K = Equal to Fast %D (i.e. 3-period moving average of Fast %K)

Slow %D = 3-period SMA of Slow %K

Notice that %K in the Slow Stochastic Oscillator equals %D in the Fast Stochastic Oscillator.

The Stochastic Slow is creates less false signal due to the smoothing effects of the moving averages.

FULL STOCHASTIC OSCILLATOR

The Full Stochastic Oscillator is a fully customizable version of the Slow Stochastic Oscillator. Users can set the look-back period, the number of periods to slow %K and the number of periods for the %D moving average.

Calculation for Full Stochastic Oscillator:

Full %K = Fast %K smoothed with X-period SMA Full

Full %D = X-period SMA of Full %K

As shown in above chart of Microsoft technology with all 3 version of Stochastic Oscillator

• %K is Blue Line and %D is red line in above chart.
• Slow Stochastic gives less false signal when compared to fast stochastic as shown in above chart
• Circle are marked where Fast Stochastic is giving false signal but that gets smotted because of Moving averages in Slow Stochastic
• %D fast(Red Line) = %K Slow (Blue)

The Stochastic Oscillator can be used to generate Buy and Sell Signals as follows

1. Extreme Values (Overbought Oversold)
2. Stochastic Crossovers
3. Stochastic Divergences

Extreme Values (Overbought Oversold)

The stochastic oscillator is plotted within a range of 0 and 100 and signals overbought conditions above 80 i.e. Index/stock is trading near its upper trading range and oversold conditions below 20 i.e. Index/security is trading near its lower trading range.

Buy when Stochastic move above 20 line.

Sell when Stochastic move below 80 line.

As shown in below EUR/USD 15 mins chart

It is important to note that overbought readings are not necessarily bearish. Securities can become overbought and remain overbought during a strong uptrend. In the same fashion oversold readings are not necessarily bullish. Securities can also become oversold and remain oversold during a strong downtrend.

Let’s illustrate the above concept with an Apple charts from 20Sep2010 Apple gave breakout and after that stock was taking support at its rising trend line and was in its bull run.

In trending market we should ignore Stochastic Overbought conditions and Oversold Conditions.

STOCHASTIC CROSSOVERS

We can use stochastic crossover to generate buy and Sell Signals as follows

Buy when Stochastic moves up from below 20 and the %K line (Blue Line) rises above the %D line (red line)

Sell when Stochastic moves down from above 80 and when the %K line (Blue line) falls below the %D line (%K Line)

As Seen from below IBM chart Buy signal got triggered @\$123.29 and Sell got generated @\$130.8

Beware though, crossovers often provide choppy signals that need to be filtered with the use of other indicators.

STOCHASTIC DIVERGENCES

Divergence occurs when the direction of the price trend and the direction of the indicator trend are moving in the opposite direction. This signals that the direction of the price trend may be weakening as the underlying momentum is changing.

There are two types of divergence –

• Positive or Bullish Divergence — Positive divergence occurs when the indicator is trending upward while the security is trending downward.
• Negative or Bearish Divergence — Negative divergence gives a bearish signal as the underlying momentum is weakening during an uptrend.

Divergences should be never taken as it is and trader should wait for confirmation to signal actual reversal.

Positive Divergence is confirmed with break of resistance on price chart and Stochastic above 50.

Bearish Divergence is confirmed with break of support on price chart and Stochastic below 50.

Let’s illustrate the Divergence with the Nifty Daily(Indian Stock Market) chart as below

As seen from above Daily Chart of Nifty, It was making higher highs as indicated in chart but Stochastic is making lower low. After market peaking out around 6324 Nifty started correcting but reversal is confirmed on breaking of crucial support. Once the support got broken Nifty gave a Bear hug correcting 8%.

This is how power of Divergences can be used by trader to get maximum profit out of his trades.

Conclusion

This leading indicator will create many buy and sell signals that make it better for choppy non-trending (Sideways) markets instead of trending markets where it is better to have less entry and exit points.

It is important to use the Stochastic Oscillator with other technical analysis tools like RSI, Bollinger band Volume, support/resistance.

Category: Technical Analysis Explained