David Waring

In our last lesson we learned about the Relative Strength Index (RSI) indicator and some of the different ways traders of the stock, futures, and forex markets use this in their trading. In today’s lesson we are going to look at another momentum oscillator which is similar to the RSI and is called the Stochastic.

Let me start by saying that there are 3 different types of stochastic oscillators: the fast, slow, and full stochastic. All of them operate in a similar manner however when most traders refer to trading using the stochastic indicator they are referring to the slow stochastic which is going to be the focus of this lesson.

The basic premise of the stochastic is that prices tend to close in the upper end of their trading range when the financial instrument you are analyzing is in an uptrend and in the lower end of their trading range when the financial instrument that you are analyzing is in a downtrend. When prices close in the upper end of their range in an uptrend this is a sign that the momentum of the trend is strong and vice versa for a downtrend.

The Stochastic Oscillator contains two lines which are plotted below the price chart and are known as the %K and %D lines. Like the RSI, the Stochastic is a banded oscillator so the %K and %D lines fluctuate between zero and 100, and has lines plotted at 20 and 80 which represent the high and low ends of the range.

Example of a Stochastic Oscillator


Whatever charting package you use will calculate the lines for you automatically but you should know that the data points which form the %K line are basically a representation of where the market has closed for each period in relation to the trading range for the 14 periods used in the indicator. In simple terms it is a measure of momentum in the market.

The %D line is very simply a 5 period simple moving average of the %K line. Lastly you should know that you can change the inputs for the indicator and use for example a 3 period moving average of the %K line to get faster signals, however as this is an introduction to the indicator and because most traders I know do not change the standard inputs, I do not recommend changing them at this point.

Like the RSI the first way that traders use the stochastic oscillator is to identify overbought and oversold levels in the market. When the lines that make up the indicator are above 80 this represents a market that is potentially overbought and when they are below 20 this represents a market that is potentially oversold. The developer of the indicator George Lane recommended waiting for the %K line to trade back below or above the 80 or 20 line as this gives a better signal that the momentum in the market is reversing.

Example of Overbought and Oversold Trading Signals


The second way that traders use this indicator to generate signals is by watching for a crossover of the %K line and the %D line. When the faster %K line crosses the slower %D line this is a sign that the market may be heading up and when the %K line crosses below the %D line this is a sign that the market may be heading down. As with the RSI however this strategy results in many false signals so most traders will use this strategy only in conjunction with others for confirmation.

Example of the Stochastic Crossover


The third way that traders will use this indicator is to watch for divergences where the Stochastic trends in the opposite direction of price. As with the RSI this is an indication that the momentum in the market is waning and a reversal may be in the making. For further confirmation many traders will wait for the cross below the 80 or above the 20 line before entering a trade on divergence.

Example of Divergence


As the RSI and Stochastic are similar in nature many traders will use them in conjunction with one another to confirm signals.

Links to Help You Learn to Trade the Stochastic Oscillator

Stochastic Oscillator (Fast, Slow, and Full) - StockCharts.com
Stochastic oscillator - Wikipedia, the free encyclopedia
Fast and Slow Stochastics Indicator- Technical Analysis

That’s our lesson for today. You should now have a good understanding of the Stochastic Oscillator and some of the different ways that traders use this in their trading. In tomorrow’s lesson we are going to look at an indicator which allows us to gauge the volatility of a financial instrument over a given time called Bollinger Bands.

As always if you have any questions or comments please leave them in the comments section below so we can all learn to trade together, and good luck with your trading!

Unregistered

Great bunch of videos and education David!

I was looking to download the Forex software and get some practice, but I noticed that you can only trade in currencies. Is that right? Is there somewhere you can recommend for stock trading over the internet?

David Waring

Hi,

Glad to hear from you and thank you for the compliment I am glad you like the videos.

For stock trading I recommend Thinkorswim.com. The offer a papertrading account and I cover how to place trades on this platform and register for their papertrading account in my logistics of stock trading course which you can find at the link below:

Logistics of Stock Trading - InformedTrades

Hope that helps. If there are any other questions or comments please feel free to post.

Best Regards,
Dave

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Disclaimer: Trading is risky and can result in substantial financial loss. As always my posts are simply one traders opinion and should not be taken as trading advice. I am not a financial adviser so everyone please do their own analysis and take responsibility for their own trades.

shish

i would recomend investopedias stock simulator Welcome to Investopedia.com - Your Source for Investing Education
have fun tradind with a real market! i find it very close to the real thing

forexer

Hi david,

As a stochastic is an oscillator, does it work well in a trending market of better in a ranging market?

And when you said there was a double top, i was kind of confused. I thought a double top can be considered a double top only if it is in an up trend. However, it was not in an uptrend. Can you please kindly clarify and correct me if my concept is wrong.

Cheers,
Forexer

Tekmnd

Hi forexer

Stochastics works better in a range market. It will show the over sold and over bought conditions (the spots where it is near the edge of the range and likely to reverse and go back the other direction).

Cheers
Tek

Tekmnd

Actually, I should add that stochastics are used lots of different ways in both range and trend, and what I listed is just the most common (at least I think it is).

Cheers again
Tek

forexer

hi Tek,

IS it right to say that the crossover of the %k below the %d when both are above 80 is a strong sell signal. AT least its a stronger signal than if the %k crosses below the %d between 80 and 20. Mind giving some tips on this indicator?

Thanks,
Forexer

Tekmnd

Hi forexer

"IS it right to say that the crossover of the %k below the %d when both are above 80 is a strong sell signal. AT least its a stronger signal than if the %k crosses below the %d between 80 and 20."

Yes, that is a correct statement. That should not be your only reason to enter a trade though. In fact, in my opinion, you should be using stochastics to confirm an entry point that you found using other means.

"Mind giving some tips on this indicator?"
There are lots of ways. Some use divergence (if you watch dave's vid on RSI, the part about divergence can be used on stochastics).

How I use it though I use a sped up slow stochastics (8,3,5 are the settings). I use it combined with bollinger bands to detect over sold or over bought conditions in a pair that is ranging (I am looking for a spot I think the pair is likely to reverse direction). I combine this with support and resistance.

In other words- when the price comes up near resistance, and stochastics is over 80, I sell when price touches upper bollinger band.
When price drops down near support, and stochastics is under 20, I buy when price touches lower bollingerbands.
First though, I look for a slight trend (even ranging, it usually will have a slight trend), and if the trend is up, I will only buy, not sell, and vice versa if the trend is down.

Hope this makes sense the way I wrote it lol

Cheers
Tek

forexer

Hi all,

I just want to know when looking for divergence, which peak of the oscillator do we use i comparison to the price. Say the price makes two consecutive higher peaks while the stochatics is making two consucutive lower troughs. which do i compare? The %k line of the %d line troughs for the above comparison. I know its a little vague but i hope someone will answer me.

Also, both the RSI and stochastic are somewhat similar right? They both indicate overbought and sold markets and work best in ranging markets. Is it wise thus to combine the rsi and stochastic to trade? Someone give me some tips on this topic. thanks.

Also, i was thinking of combining the bollinger bands with the stochastic. when the bands are narrow, low voletilty, i should consider the stochastic. However if the bands are wide, i should ignore the stochastic and switch to another indicator, say a MACD. Is this wise?