Stochastic oscillator, to detect overbought and oversold
We dedicate this lesson to the Stochastic Oscillator , also known simply as “Stochastic.” It is quite a complex subject as this concept is found in various disciplines, including mathematics and statistics. However, we will try to be as synthetic and practical as possible, highlighting what is needed for online CFD trading .
The stochastic oscillator, in fact, proves to be very useful in the short or very short term dynamics characteristic of CFD trading. To put it into practice, it is advisable to use a platform in demo mode, even without depositing and with virtual funds. You can practice, for example, with this platform offered by eToro .
What is the stochastic?
It is an indicator created in 1970 by a luminaire called George Lane , with the aim of evaluating how close the closures of the bars were in the vicinity of the minimum or maximum of a given period.
Lane’s intuition was as follows:
As a general rule, closes of bars (bars or Japanese candlesticks) near their highs are typical for uptrends, while closes of bars near their lows are typical for downtrends.
It is a simple but brilliant intuition. By reflecting on this information, you will understand why it may be so important in trading and market predictions. Stochastic, in fact, is one of the best tools to identify overbought and oversold areas, from which to predict so-called reversals.
Stochastic Oscillator Formula
Although you will never need to calculate it yourself, as you will always be the trading platform to do so, let’s find out how the stochastic oscillator formula is composed so that you can understand the logic of its operation.
% K = 100 * [(CLOSE – MINn) / (MAXn – MINn)]
Where:
MINn = Low of the last n days
MAXn = High of the last n days
CLOSING = closing price of the last session (today)
The value n is not fixed, but can be configured as desired on the trading platform. The creator of the Stochastic Oscillator, George Lane, preferred the 14-period setup , although it all depends on the market you are trading in .
The formula then becomes:
% K = 100 * [(CLOSE – MIN14) / (MAX14 – MIN14)]
With this formula we compare the most recent closing price with the minimum price in a given time interval, which in the case of this formula is composed of 14 periods.
The stochastic calculation then compares the present value and relates it to the maximum and minimum values of the registered price in a certain period of time. With this calculation, the value of% K is obtained, which subsequently allows determining% D, that is, the value of the defined mean.
Types of stochastic
Stochastic can be presented in three different types or versions: fast, slow, full.
- Quick or Quick: Basically based on George Lane’s original formula. With this formula% K, it is calculated by relating the percentage of the closing price to a given price range over 14 periods. The% D line, on the other hand, is given by the moving average of the% K line (which is usually 3 periods). This formula is quite criticized because the stochastic obtained with it is very reactive and difficult to apply.
- Slow or Slow: To remedy the shortcomings of the fast version, or its reactivity, this formula has been designed with% K given by a 3-period moving average of the% D line of the fast stochastic. Then it can be said that the slow stochastic is a derivative of the fast stochastic since its value is calculated from it. The% D line of the slow stochastic is the 3-period moving average of the new% K line.
- Complete or complete: it is a variant of the slow stochastic. This is a customizable version where the user can modify the parameters (number of periods for% K, number of periods for% D).
Trade: how is stochastic used?
This is both because there are no sudden changes and because this oscillator is optimal for the side phases of the market. A side market phase is one in which there is no well-defined trend. Another optimal factor for the stochastic oscillator is the short term. So, in summary, the Stochastic Oscillator is used in short-term and sideways market situations.
Considering an action with prices that follow a certain irregularity, without well-defined trends, with movements that are not smooth, often overlapping, we can define it in a lateral situation.
Proceeding at the operational level, we first identify 2 points at the top and 2 points at the bottom, drawing two trend lines and a projection. Once this is done, we will operate:
- Buy : if the price touches the lower trend line and the two stochastic lines intersect in the oversold zone
- Selling : if the price touches the upper trend line and the two stochastic lines intersect in the overbought zone
How to behave with a trend?
We have said that the stochastic oscillator is ideal for lateral phases . However, if you are able to identify a trend with “certainty”, or if you are in a well-defined trend , you can take advantage of the pullback, going in the same direction as the original trend to try to take advantage of the end of the correction.
In simpler words, when a price is moving in one direction steadily and sharply and we can consider it as a trend, we can assume that this trend will continue its path even after a slight correction.
Then:
- A buy signal is generated when the stochastic lines cross in the oversold area.
- A sell signal is generated from the moment the stochastic lines cross in the overbought area.
What to do in case of difference?
We have seen how to trade in case of a side market and a trend market. Now let’s look at the case where we have a divergence , understood as a divergence between prices and the oscillator.
If we find ourselves in a situation where the price marks two falling highs and two rising highs occur at the same point (see lesson on double highs and double lows), we could find ourselves in a phase of bearish divergence and the stock could turn around. Obviously the same applies in reverse, where we would have a bullish divergence.
In any case, it is recommended to wait for divergences in a slight trend phase or in a lateral phase, since the probability of success of the signals is certainly higher.
Many analysts and traders use stochastics as a launching pad, as a filter before opening a bullish or bearish position, in order to integrate the signals obtained with other indicators.
Analysis with the stochastic oscillator
In this lesson we will see how to make an analysis of the stochastic or a chart to which the stochastic oscillator has been applied . So to get started you should have a chart like the one below. As you can see, we have applied a stochastic oscillator to the real-time chart of the EUR / USD instrument. To do this, we used the Plus500 platform, clicked the f (x) button that you see here in the blue border, and then we chose “stochastic” from the list of applicable functions.
As you can see, below the Japanese candlestick chart for the currency pair are the stochastic lines:
- Green line:% K
- Blue line:% D
If you don’t remember what% K and% D are, we refer you to the first lesson on the stochastic oscillator.
To perform the analysis we must divide the graph into three areas: 0-20, 20-80, 80-100.
Stochastic 0-20 zone
The 0-20 zone of the stochastic chart represents the oversold zone, which is an area where the stochastic indicates the presence of strong or rather “interesting” price declines . In fact, precisely because the oscillator reaches this area we must act and understand if it is the right time to focus on the investment and therefore on the rise . In fact, let us remember that the goal of stochastic is precisely to predict and “catch” reversals, focusing on new trends. This is the most efficient way to profit from CFD trading and trading in general, and therefore also from investing through traditional brokers.
Well, when the oscillator reaches the 0-20 zone, it is also time to study the entry with a long position.
It should be noted that it is also necessary to analyze the context in which the oscillator reaches this position, since if it arrives there in constant downward market conditions, it will be very likely that there will be a break in the trend and therefore a reversal. If, on the other hand, the oversold condition occurs due to micro or macroeconomic factors, the reversal may not necessarily occur in the short term, as the decline is due to fundamental and non-technical factors.
So to sum it up, we can say that the stochastic oscillator offers reversal trading signals to the upside when the price reaches the 0-20 zone at times when the market is not particularly affected by microeconomic factors (for example, the quarterly balance of a company in the case of stocks) or macroeconomics (for example, the change in interest rates of a state that issues currency).
20-80 stochastic zone
In this zone, the stochastic oscillator offers no entry signals. It should be noted that the oscillator can be in this zone even when there is a constant drop or rise in price. In fact, the stochastic reaches above 80 or below 20 only in situations where the rise or fall accelerates in an “interesting” way that suggests a reversal.
Stochastic zone 80-100
This is the situation diametrically opposite to that of the 0-20 zone. When the stochastic oscillator reaches the 80-100 zone there is an overbought situation and therefore you can start studying the right moment to bet on the downward reversal .
Again, if it hits the overbought zone after a long uptrend, it is more likely to reverse.
Intersections
In stochastic analysis, you have to take into account the crosses , which play a “crucial” role to say the least, to use a pun. As stupid as it may be, remember this pun to remember the intersections when using the stochastic:
- In case the blue line reverses its trend and crosses the red line, there is a buy signal.
- In case the red line reverses its trend and crosses the blue line, there is a sell signal.
- If you follow a trend and a cross becomes more incisive, you have a strong signal in the same direction as the current trend . In this case, line% D will cross line% K
- When the price chart shows two highs and at the same time the stochastic indicator shows a downward trend, there is a strong signal of a weakening of the current trend and therefore a strong reversal assumption in a very short time.
Go to the next lesson on the Crocodile or Crocodile indicator.
Stochastic FAQ
What is the stochastic?
Stochastic is an oscillator type indicator, highly appreciated in the analysis of financial markets . When is stochastic used?
It is used to identify overbought and oversold areas. How is the stochastic calculated?
With the formula% K = 100 * [(CLOSING – MINn) / (MAXn – MINn)] where MINn is the minimum of the last n days, MAXn is the maximum of the last n days, CLOSING is the closing price of the last session (today). What signals does the stochastic offer?
Stochastic can offer excellent signals of a price change by identifying oversold and overbought levels.