Stochastic indicators, also known as stochastic oscillators, are among the leading momentum indicators for investors today. They typically use them to predict trend reversals, focusing on price momentum to identify overbought and oversold share levels. The main idea behind using such indicators before trading is to make a sound and informed trading decision with less risk vulnerability.
Therefore, to make your trading journey profitable, you must also understand the metrics bend the stochastic indicators. Let’s understand the real story behind its Renko charts and how you will use them to make your trading profitable.
How Does The Stochastic Indicator In Trading Work?
The formula of the stochastic indicator is simple. It is;
%K=100(C- L14)/(H14- L14)
Here, C = the most recent closing price of the instrument
L14 = the lowest price of the instrument in the last 14 days
H14 = the highest price of the instrument in the last 14 days
%K=100(C- L14)/(H14- L14)
Here, C = the most recent closing price of the instrument
L14 = the lowest price of the instrument in the last 14 days
H14 = the highest price of the instrument in the last 14 days
Using this formula, the stochastic indicator helps you focus on the closing point of an instrument with close relation to its highest and lowest points over some periods, typically 14. This then acts as a Moving average convergence/divergence (MACD) to help traders identify price trends, measure trend momentums, and decide their entry and exit points.
The stochastic indicator has two lines that fluctuate between 0 to 100, applying which you can predict price reversal points in any chart. Let’s understand how it works through the below pointers;
The stochastic indicator has two lines that fluctuate between 0 to 100, applying which you can predict price reversal points in any chart. Let’s understand how it works through the below pointers;
- The two stochastic indicators are the “%K line,” shown by a white line, and the “%D” line, shown by a red line.
- The indicator deals with 14 individual periods, which means that in hourly charts, it deals with 14-hour metrics, whereas in weekly charts, it deals with 14-week price ranges.
- When the stochastic oscillator's indicators rise to a higher point, it suggests that the instrument's price is close to its highest point in the previous 14-period range.
- In contrast, if the indicator is low, it denotes a lower price closing in the 14-period range.
- Therefore, the indicator will surge towards the high in an upward-trending market. Whereas if the indicators are low, it suggests a downward-trending market.
- A gradual lowering of the indicators from the higher to lower position therefore indicates that the price momentum of the asset is slowing.
Applying this indicator using any leading algo trading software to identify trend reversals and get your overbought and oversold readings. Now let’s see how you can read the indicator.
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How Will You Read The Stochastic Indicator?
As it is mentioned earlier, the stochastic indicator ranges from 0 to 100. Based on its position from 0 to 100, you can read its indications like;
- The reading is above 80: The asset is trading near the height of its 14-period range. This indicates that the instrument is overbought.
- The reading is below 20: It means the asset is trading near the bottom of its 14-period high-low range. This indicates that the instrument is oversold.
- The reading is above 50: It indicates that the instrument is trading in its upper trading range whereas a below 50 reading signals that it is trading lower than its usual trading range.
- If it falls from 80 to below 50: It signals that the instrument’s price is moving lower.
- If it rises from below 20 to above 50: It indicates that the instrument’s price is moving higher.
While reading the stochastic oscillator, traders can also find out diverging points, when the stochastic line and the price tradeline move away from each other. This indicates a weakening price trend that may soon reverse.
You Will You Use The Stochastic Oscillator?
Now that you have a sufficient note on the stochastic oscillator, let’s understand how you can use it to improve your trading operations. Below are the strategies you can undertake using the stochastic indicator in an option trading app.
->Oversold and Overbought Strategy
By looking at the stochastic indicator, you can learn if an instrument is overbought or oversold. Based on this information, you can decide whether to buy or sell the instrument.
A stochastic indicator can signal that you should buy an instrument if it goes below 20 and then rises above. This shows that the instrument is oversold, a favourable time for you to buy it.
In contrast, when the stochastic indicator goes above 80 and falls below, it gives you selling signals by indicating that the instrument is overbought.
However, while applying this strategy note that an overbought signal does not necessarily result in a price fall. Similarly, an oversold signal does not automatically raise their price.
A stochastic indicator can signal that you should buy an instrument if it goes below 20 and then rises above. This shows that the instrument is oversold, a favourable time for you to buy it.
In contrast, when the stochastic indicator goes above 80 and falls below, it gives you selling signals by indicating that the instrument is overbought.
However, while applying this strategy note that an overbought signal does not necessarily result in a price fall. Similarly, an oversold signal does not automatically raise their price.
-> Stochastic Divergence Strategy
Traders can use stochastic indicators to predict a reverse trend if the indicators diverge from the instrument’s price. For instance, when an instrument’s price gets to its lower low but the indicators touch a higher low, it indicates a bullish divergence. This can mean that the selling pressure is decreasing, and an upward reversal may occur.
In contrast, when the instrument’s price reaches a higher high but the indicator touches the lower high, it shows a bearish divergence. This could possibly mean that the upward momentum is slowing down, indicating a downward reversal.
However, while following the stochastic indicators to apply your divergence strategy, wait until you notice a turnaround in the price range. This is because, instead of a divergence, the instrument’s price can continue to rise or fall for a significant time.
In contrast, when the instrument’s price reaches a higher high but the indicator touches the lower high, it shows a bearish divergence. This could possibly mean that the upward momentum is slowing down, indicating a downward reversal.
However, while following the stochastic indicators to apply your divergence strategy, wait until you notice a turnaround in the price range. This is because, instead of a divergence, the instrument’s price can continue to rise or fall for a significant time.
-> The Bull and Bear Strategy
Like the divergence strategy, the difference between the instrument’s price and the signals of the stochastic indicator makes it possible to predict a bullish and bearish trend timely. If indicators go to a higher high but the instrument price hits a lower high, it indicates a bull trade. Such a trend signals you to make a buying decision as the share’s prices will increase.
On the other hand, you can predict a bearish trend when the instrument’s price is showing a higher low but the stochastic indicator indicates a lower low. Here, the stochastic indicators directly suggest that you should sell your shares as the instrument’s price can go much lower.
On the other hand, you can predict a bearish trend when the instrument’s price is showing a higher low but the stochastic indicator indicates a lower low. Here, the stochastic indicators directly suggest that you should sell your shares as the instrument’s price can go much lower.
-> The Crossover Strategy
Another popularly used trading strategy with stochastic indicators is the crossover strategy. It occurs typically when the %K and %D lines cross in an oversold or overbought region.
When you can see an increasing %K line crossing above the %D line in an oversold region, it indicates you have bought the instrument. In contrast, a decreasing %K line below the %D line in an overbought region indicates a selling signal.
However, when planning your trading strategies based on the signals of stochastic indicators, remember that these are technical tools with limitations. You cannot fully rely on them, as they may often generate false signals. Especially during a volatile market condition, stochastic indicators can often mislead you.
When you can see an increasing %K line crossing above the %D line in an oversold region, it indicates you have bought the instrument. In contrast, a decreasing %K line below the %D line in an overbought region indicates a selling signal.
However, when planning your trading strategies based on the signals of stochastic indicators, remember that these are technical tools with limitations. You cannot fully rely on them, as they may often generate false signals. Especially during a volatile market condition, stochastic indicators can often mislead you.
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Conclusion
In essence, to make a profitable trading operation, you will have to read the signals of stochastic indicators consistently. With regular monitoring, you will be able to consider the real dynamics of the stock market and be more confident in your trading decisions.
Option trading apps help you make this timely analysis of chart patterns to decide your entry and exit points. In this matter, SpeedBot is undoubtedly the best option and algo trading app that you can trust, just like millions of Indian traders do.
Option trading apps help you make this timely analysis of chart patterns to decide your entry and exit points. In this matter, SpeedBot is undoubtedly the best option and algo trading app that you can trust, just like millions of Indian traders do.