The Stochastic Oscillator is one of the most popular trading indicators. Generally when prices begin rising Stochastic rises and when price falls the Stochastic indicator falls. However psychology is important in trading, fear and greed rule the markets and fear and greed generate momentum in prices. Stochastic is created by a formula that judges momentum.
Markets always rise and fall, in uptrends they rise more than they fall and in downtrends they fall more than they rise, however a trend always has pullbacks. In a ranging market there are swings in prices within a certain range. This movement is like a heartbeat to the market.
Markets make lows and they make highs. In uptrends there are higher highs and higher lows, in downtrends there are lower lows and lower highs. In ranges prices duck and dive making lows and highs within the range. Stochastic will measure momentum within these moves.
Momentum trading indicator
Think of throwing a ball to a friend. You launch the ball into the air. It seems to hang in the air for a period of time (still rising) before plunging downwards into the hands of your friend. One of the trickiest things to judge in trading is, when is price running out of momentum? When is the ball going to start falling?
The time to exit a buy trade is when momentum is reaching its peak. Not after it has already lost its momentum. When momentum is lost the ball will fall rapidly. The trouble is that if you just look at prices then you will find it really difficult to exit a trade at this stage. All you will see is that prices are still rising. Greed could prevent you from exiting. Also the fear of missing out on further possible profit could prevent you from exiting. However if you could see price slowing, momentum gone, just before price begins to fall then this would be useful, wouldn’t it? This is one thing that the Stochastic indicator can help you with.
What is the Stochastic indicator?
Like all indicators Stochastic is based on price, however it gives a slightly different interpretation of price action than just looking at prices alone.
Stochastic takes into consideration Closing Prices, Low Prices and High Prices within a period.
If price within a period keeps making similar highs and lows but the closing prices are lower each time then a simple graph based on a line joining up the high prices will show prices as being stagnant for that period even though they have been closing lower. This does not represent the price action accurately enough for traders (which is one reason why price candlesticks are preferable to a mountain range type line). As the Stochastic formula takes into consideration high prices and closing prices in this situation the Stochastic Oscillator will start pointing down – showing that momentum is in the direction of lower prices.
If bears keep fighting off bull rallies to close the prices lower then it is the bears that are gaining control even though the average price for a period may be equal to that of the previous period.
As the creator of the Stochastic indicator, George C. Lane pointed out – “It follows the speed or the momentum of price rather than price itself. As a rule momentum changes direction before price.”
Stochastic Indicators have two lines associated with them. A faster line (K) and a slower line (D). The slower line is a moving average of the faster line.
Both lines are plotted in a range and will be somewhere between 0-100. A percentage. The first line is referred to as K. The second line is D.
There are three variable user defined values for Stochastic. The Look-back period for K. The Smoothing Period of K. Moving Average of the smoothed K line which makes up line D.
Essentially the higher the values the longer the period over which you are monitoring momentum. The longer the period and the more smoothing you apply the less reactive the indicator.
The more that I look at the formulas the more mist descends on me! More importantly you should choose values for Stochastic that help produce trading signals that are useful for you. There are no right or wrong values. There are no perfect values. Typically traders use 14,3,3 and 5,3,3 most often. The first set of values produces a less reactive indicator than the second. Which set of values are right for you? This comes down to your trading system and trading style. Which we can help you work on in our training course.
Here are three examples for you of Stochastic using different settings and based on the same timeframe and price action.