Trading with Stochastic indicator: How to improve your strategies?

The Stochastic indicator is an oscillator used in technical analysis. Stochastic tracks the relationship between each closing price and the recent range of highs and lows.
Stochastic measures the ability of bullish or bearish investors to close a price near the day's high or low.

What is Stochastic?

Stochastic (or stochastic oscillator) is an indicator developed by George Lane that consists of two lines known as %K and %D. It is based on the fact that when prices are rising, the closing price is closer to the highs of the day and when prices are falling, the closing price is closer to the lows of the session. Stochastic is calculated by taking into account the closing price of the session and the price range for the calculation period. Next we will explain the formulas used.

The formulas for calculating the two lines of the stochastic indicator are as follows: %K=100*(C-Min)/(Max-Min), where:

• C= Current close;
• Min= Minimum number of last sessions, according to the selected timeframe P;
• Max= Maximum number of recent sessions, according to the selected timeframe P;
• %D= Simple moving average of %K over n periods.

To calculate %K we usually use the value 14 for P, i.e. 14 sessions. Similarly, for %D we use the value of n between 3 and 5 periods. In other words, %D is a moving average between 3 and 5 periods of %K. Hence, %D is a smoothed or flattened %K indicator. It should also be remembered that a simple moving average is the arithmetic mean of a selected constant number of observations. For each new period, the most recent value is taken and the oldest value is discarded.

This classic Stochastic, is known as the fast Stochastic. Another version is also used (slow Stochastic) uses 3 parameters, the last of which is the new smoothing applied to the lines, whose default value (for n) is usually 3.

What is the purpose of Stochastic?

The functionality of Stochastic is seen when values are not strongly trending. It is used to identify the various zigzags that prices move through and gives buy and sell signals. Stochastic is a standard indicator that moves on a scale from 0 to 100 and has two zones or levels that take on special significance when the indicator reaches them. Stochastic indicates that:

• An asset is oversold if the stochastic lines (%K, %D) are in the zone between 0 and 20;
• An asset is overbought if the stochastic lines are between 80 and 100.

Remember, the trend change signals given by Stochastic are stronger if Stochastic is in an overbought or oversold zone.

Strategies using the Stochastic indicator

Using the Stochastic indicator, you can follow several effective strategies based on watching the crossing of the lines. One strong buy signal occurs when the %K line crosses the %D line from bottom to top, especially if it occurs in an oversold zone, indicating a possible upward market reversal. A sell signal occurs when the %K line crosses the %D line from top to bottom, especially in an overbought zone, indicating a possible downward trend reversal. These signals help traders make more informed decisions in the face of market uncertainty.

Line breaks signify a change in the direction of price movement, but the problem is that it is impossible to quantify the amplitude of the movement. It should be noted that when we talk about buy signals, we mean that an investor should open a long position or close a short position. Similarly, a sell signal means opening a short position or closing a long position.

Another strategy for using Stochastic is to observe the behaviour of the %K and %D lines as they move out of overbought and oversold zones. A buy signal occurs when both lines start to move upwards and leave the oversold zone, indicating a possible start of growth. At the same time, a sell signal occurs when the %K and %D lines turn downwards and leave the overbought zone, which may herald an imminent decline. These reversals help to catch the key moments in the market and make decisions at the right moment.

Strategies with divergences on Stochastic

Another strategy is the use of divergences on the stochastic oscillator, when the %K and %D lines are compared to the movement of quotes. In the case of a bullish divergence, when prices are declining but the oscillator shows a rise, you should consider buying with a protective stop below the last low. On the contrary, in case of a bearish divergence, when prices are rising but the oscillator shows a decline, it is recommended to sell short and place a stop loss above the last high. Such divergences help to identify hidden signals and protect your trades from unexpected market reversals.

Trading recommendations for using Stochastic

If the market is trending, Stochastic indicator crossovers outside of overbought and oversold zones can be a great time to increase positions in the direction of the current trend. If the market is in a strong uptrend, it is wise to increase long positions when the %K line crosses the %D line from above. On the contrary, in a strong downtrend, it is worth increasing short positions whenever the %K line crosses the %D line from below. 

This strategy helps you to follow the main trend and optimise your entry points in the market, strengthening your positions. This pyramid strategy with a stochastic oscillator will significantly increase your profits on winning positions. Remember that you need to be much stricter with stop losses (limiting losses).

Conclusion

The Stochastic indicator is a versatile tool that can greatly improve your trading decisions, whether in a trending market or a sideways market. Its ability to pick up buy and sell signals, especially in overbought and oversold areas, makes it a valuable assistant for traders. Proper use of this oscillator can increase the efficiency of your strategies and help you react to market changes in time.