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Stochastic Oscillator: Everything you need to know

Summary

  • The Stochastic Oscillator is an indicator designed to present the location of a stock’s closing price with the context of the period high and low range.
  • The Stochastic Oscillator can detect pattern breakouts, trend reversals, and even reveal bullish and bearish divergences.

Stochastic Oscillators

Traditional investment advice would suggest traders buy low and sell high, but with the unpredictability of market movements, this can be hard to follow consistently. Considerably more so in cryptocurrency markets, it can be much more profitable to stop trying to time the highs and lows instead of trading the waves between them.

Investors employ techniques to use momentum when they see an acceleration in an asset’s value, often taking long or short positions based on the direction of momentum. While skilled traders can successfully pull this off, much of it depends more on erratic short-term movements than fundamental value.

What are Momentum Indicator?

Traders use momentum indicators to track this growth rate and buy or sell based on the signaled trend strength. Using a momentum-based strategy, traders take long positions when prices trend upwards and short positions when prices downtrend.

Instead of selling high and buying low, momentum traders identify opportunities to profit from high liquidity markets, buying high and selling higher or selling low but buying even lower. Momentum investors focus more on the prevalent trend created after the last price break rather than detecting continuation or reversal patterns based on past movements.

Momentum is like a train, accelerating slowly but exponentially and decaying similarly. For momentum traders, the zones where the acceleration is at its peak are what really bring the money home – when the train is moving fastest. Momentum investors crave performance, reaping returns from stocks trending in any direction.

The upward trending prices or ‘hot stocks’ are the ones with the most significant growth over time, and some investments are hotter than others. Using momentum indicators like RSI (Relative Strength Index) and MACD (Moving Average Convergence/Divergence), traders can perform a technical analysis that determines strengths and weaknesses in an asset’s price.

Trading momentum represents the rate of rising or falling in an asset’s price. From the perspective of observing trends, momentum is incredibly helpful in determining price strength. However, momentum has historically been more applicable during rising markets than falling ones, but this is mostly because bull markets tend to last longer than bear markets.

What is The Stochastic Oscillator?

In the 1950s, George Lane developed the Stochastic Oscillator, an indicator designed to present the location of a stock’s closing price with the context of the period high and low range. The indicator is typically measured in 14-day intervals. Through multiple interviews and conversations, Lane maintained that the oscillator did not follow an asset’s price or volume, but its momentum.

According to Lane, an asset’s momentum changes before its price. In this way, the Stochastic Oscillator can detect pattern breakouts, trend reversals, and even reveal bullish and bearish divergences. Traders will use any opportunity to make a profit, and while momentum trading isn’t the easiest to pull off, it can be very lucrative.

How to trade with the Stochastic Oscillator?

Contrary to popular misconceptions, stochastics is not a fancy word for people who trade stocks and actually refers to the inherent random properties of a system. As mentioned above, the stochastic indicator is a momentum indicator that compares the closing price of a security to its high/low price range for a given period.

Traders can minimize the oscillator’s sensitivity to market fluctuations by varying the time interval or by using its moving averages. The method behind the stochastic oscillator’s madness involves the general theory that prices close near the highs in markets trending upward and near the lows in markets trending down.

The %K and The %D Lines

  • %k = (Last Closing Price – Lowest Price)/(Highest Price – Lowest Price) x 100
  • %D = 3-day SMA of %K

The indicator consists of two plots, the %K and the %D lines, calculated using the closing price and period highs and lows. %K represents the ratio between the growth of the current closing price from the period low to the period high/low range, and the signal line or %D is the average %K over the last three periods.

Stochastic Crossover

Trade signals occur when the %K and %D lines cross each other. These plots swing between the indicator’s extremes of 0 and 100, with overbought and oversold zones beyond the 80 and 20 levels.

While traditionally, above the 80 mark denotes an overbought market, and below 20 indicates an oversold one, these numbers aren’t always representative of an incoming reversal. In fact, strong trends can maintain overbought and oversold levels for extended periods of time, and traders should closely observe the changes in the stochastic oscillator to find clues about future movements.

When the %K crosses over the %D, it means the current momentum is higher than the three-period average and that an upward trend may be incoming. This is because the price is thought to follow momentum, and the intersection of the two plots is a signal of a sizeable day-to-day momentum shift.

Since oscillator signals usually precede price action, a divergence between the stochastic oscillator’s calls and the current price trend could be interpreted as an impending reversal. This is ordinarily due to exhausted buying or selling pressure as momentum fizzles out towards the end of a market cycle.

Most charting tools come with a stochastic oscillator function built-in, but traders can easily use it even without the need for complex calculations. For example, if the period high was $200 and the low was $100, a closing price of $150 would produce a %K of 50. Through comparing the current price to the high/low range over time, the stochastic oscillator allows traders to consistently note regions where the price is healthy and trade the market’s momentum.

The stochastic indicator has advantages beyond just tracking overbought and oversold regions. For one, the oscillator is preferred in ranging markets, where the price itself shuttles between a period high and low. In these scenarios, the stochastic oscillator can be incredibly reliable.

Stochastic oscillator vs. The RSI

Another indicator, the RSI, is also an oscillator that measures market momentum and is widely used in technical analysis. While they are often thought to be fundamentally similar, they actually follow different underlying theories.

The RSI uses the velocity of price movements to track overbought and oversold levels, while the stochastic oscillator assumes that prices close in the direction of the trend. RSI is generally thought to be more useful in trending markets, while the stochastic oscillator dominates more in consolidating and ranging markets.

No trading style is risk-free, and this also can be said for momentum trading. Regardless of the kind of market and how accurate the signals may seem, indicators can sometimes just be flat out wrong. No indicator can guarantee a price trend, and it’s essential to read the stochastic oscillator’s signals with this in mind.

Especially in cryptocurrency markets, it’s vital to prepare for sudden reversals and corrective movements. Divergence signals can take time to play out in the price, and making up for this delay is part of the momentum trading process. This can also vary between investments, but with some experience, patterns emerge even among the most disparate of assets.

Price Movements and Stochastic

Traders ultimately profit from price movements, but stochastics measures price momentum, which is an important distinction. A full stochastic oscillation from the 20 to the 80 level may result in a greater gain than a drop from the 80 to the 20 level. Its fluctuations are not proportional to price movements, and this inconsistency has turned off many a trader.

It arises due to the stochastic oscillator’s focus on momentum, making them far more robust when aligned with market trends. Prices prefer to move alongside the overall trend, meaning buying an uptrending stock is more impactful than selling.

Combining the Stochastic with Other Technical Indicator

Like any indicator, the stochastic oscillator is best used when combined with other tools to create a more robust idea of market conditions. The RSI, while similar in utility, is used in conjunction with the stochastic oscillator quite often. While momentum indicators like these are useful for trading ranges, they can also prove surprisingly valuable in trading assets trending in zig-zag patterns.

In these cases, pullbacks are considered part of a larger uptrend, and bounces are formed in downward trending markets. For these scenarios, the stochastic oscillator can be used to identify opportunities that resonate with the larger trend, as well as turns that take place near support and resistance regions.

An asset trading near its supports (while exhibiting an oversold stochastic oscillator) breaks above the 20 level to signal a successful support test, and breaks under 80 to signal a downturn and failed resistance. However, the exact settings may vary from trader to trader based on personal preferences, time-frame, and trading style.

Shorter lookback intervals produce choppy oscillations with too many extreme readings, while longer ones provide a smoother reading with less overbought and oversold levels. Other technical analysis tools like volume indicators and moving averages can also be used to confirm or contradict stochastic signals.

While the stochastic oscillator almost certainly has its advantages, it’s vital to understand its relationship with price movements before using its signals to profit. This indicator was developed over sixty years ago, and its high accuracy price momentum tracking has kept it relevant to this day.

Risk Management when using the stochastic oscillator

However, as mentioned above, the stochastic oscillator is prone to generating false signals during strong trends, and it’s typically better to wait for confirmation from other indicators in these cases. The indicator’s sensitivity can be tweaked to match different markets and trading styles, and by altering time-frames and using a moving average of the oscillator, many of these false signals can be ignored.

Fast and Slow stochastic Indicators

Traders make use of both fast and slow stochastic indicators to draw predictions in different kinds of markets. Fast stochastic oscillators are more sensitive to changes in the price of the asset, while slow ones are more softly drawn. Momentum trading isn’t a perfect strategy, but it offers an approach that balances risk and reward quite well.

However, a high monthly turnover can quickly become expensive due to fees, and while low-cost brokers and decentralized finance are slowly eradicating this issue, it still plagues the lives of newer traders. Momentum traders also need to observe the markets as often as possible, as the assets they deal with are usually volatile and ranging.

Conclusion

Learning even the smallest bit of news earlier than others can lead to huge profits, while even the tiniest bit of negative information can spook investors away, devaluating their assets. The margin for profit from momentum trading is much higher during bull markets when traders are known to hoard assets and exhibit low investor caution.

Momentum trading can be incredibly profitable in the right hands, but purchasing rising or falling assets based on old news can have drawbacks. In some circumstances, momentum trading can leave you holding a bag of tokens that have become worthless from the lack of demand, usually when the markets fail before a reversal is detected. It takes intuition, skill, and discipline to trade momentum, and while the stochastic oscillator is insightful, it isn’t all-knowing.

Trading momentum requires quick decision-making and the ability to conduct a trade at the first sign of strength or weakness. With blockchain slowly sprouting into a mature industry, the space’s market capitalization is higher than ever. As developers, entrepreneurs, and investors continue to produce valuable services to bet on, the next few years could see far more investors attempt to buy high and sell even higher.


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