What makes you use stochastics indicators for your trading?
Most of you will answer it "because it is easy and reliable."
Let me tell you that it is more than that.
And therefore, in this blog, you will understand its basic concept to its technicality in the stock markets.
Using a stochastics indicator strategy helps traders understand a trend's momentum and strength. The indicator analyses the price of a stock to predict its strength in the market. Stochastics falls in the category of oscillators in technical indicators.
The developer of the Stochastics in stock market is George Lane, a technical analyst, securities trader, and speaker. A definition by George Lane will help you grab the concept better,
"Stochasticsare an indicator that measures the momentum of price. If you observe a rocket going up, you should know that to turn it down; it must slow down. Momentum always changes its direction before the price."
According to George Lane, we can perceive that the indicator assesses the relationship between a closing price and the entire price range over a predetermined period.
You need to remember that the stochastics oscillator measures the price momentum as it will frequently change before it can change its direction; we will understand the definition of momentum shortly.
Stochastics are indicators that perform reliable buy and sell signals to help trades predict the downward and upward trends. It is also used to show when the stock is in an overbought or oversold position.
Chartists should carefully select the chart period – weeks, days, or months to represent the stochastics accurately.
After a basic understanding of stochastics, let's hop on to understand its concept in detail.
A stochastics indicator is range-bound and can be analyzed within 0 and 100. The concept of stochastic is larger than the stock market because it is also used as a mathematical model in several situations.
In technical analysis, stochastics refers to a group of oscillators that helps in defining a buying or selling opportunity in the market.
Stochastics oscillator in trading defines momentum, oversold, overbought, and several signals, which we will understand below:
One should be familiar with momentum before diving into the stochastics concept's finer points.
Momentum is the rate of acceleration that is observed in the price of a security. The stochastics indicator uses momentum to spot the buying and selling trend in the price movement.
From the standpoint of technical analysis, the use of momentum indicates the strength and weakness of the issue's price. Market rises for a reason and falls for a reason, too; thus, momentum is why the rise and fall occur.
Traditionally, the range-bound stochastics suggest that the stock indicates the overbought and oversold conditions through the readings over 80 and under 20. The stock over 80 is considered overbought, and below 20 is considered oversold.
However, apart from the traditional approach, the modern approach tells us to be aware of the overbought and oversold conditions while trading. Experienced chartists think that the overbought and oversold are misinterpreted and which is considered one of the biggest risks in trading.
As stated above, when Stochastic is above 80, it is overbought, and when it is below 20, the price is oversold. Traders often sell in when the stochastic is overbought and buy when it is oversold, which as per the modern approach, is wrong.
To understand, traders should observe above 80 stochastics as a strong trend instead of overbought. You should know that the stochastics show strong signals with ongoing momentum.
Take an example from the figure above; the behavior of the stochastic above 80 is overbought in a long uptrend and downtrend movement. Therefore, traders should trade by taking the trend as strong momentum and not because it is overbought.
Stochastic signals are useful and common signals used by traders to track the price momentum of the stock. Some of the stochastic signals that a stock market trader should know:
5.1 Trend Reversal
The trend reversal signal occurs when the direction and moves of the stochastic change from the oversold or overbought position. In this situation, a trend reversal takes place. There are several trend reversal stock screeners available online for you to screen your trading aspects.
5.2 Strong Trends
A stochastic develops a strong trend when it is in the overbought or oversold areas; therefore, hold on to the trades by sticking with the trend. A stronger trend is likely to happen soon from the overbought/oversold area. You can look at the figure above to spot it.
5.3 Trend Following
Remember that stochastic is in a strong trend if it is following new prices in a single direction. Valid trends can be generated in one direction, and trend reversal can indicate a change in trend.
5.4 Breakout Trading
A breakout happens when a stock is trading sideways for a long time or is suddenly accelerating in one direction. The two stochastic bands widen in this situation to signal the breakout trend.
Divergences are an important signal that helps find the potential trend reversal from the security price. The below chart shows the trend reversals from upward and downward movement trends.
Stochastics is a great indicator- reliable and easy to predict the price momentum; however, you should use it with several other combinations (indicators) to have accuracy with analysis.
6.1 Moving Averages
Stochastics with moving average strategy help monitor long-term strategies that reveal the support and resistance levels.
Moving average works great with stochastics because it compliments the trading signals found by the crossover.
Usually, a daily chart and stochastic setting of 14, 3, and 3 work great with moving averages. The drawback of crossover is that sometimes it remains in the overbought or oversold position for a long time. Due to sideway trend indication, some traders ignore using this strategy.
Stochastic oscillators indicate trend reversals and divergences which are useful when used with trendlines. When you are done establishing a trend, drawing a valid trendline will confirm your stochastic analysis.
As per the figure above, the stochastic line and trendline complement each other to denote the trend reversal happening on the trendline's break.
6.3 Price Analysis
A trader should carefully look for price formations if he expects a breakout or reversal trade. Always look for wedges, rectangles, and triangles because a potential breakout can occur on breaking such price formations.
Key Takeaways and Rules
Stochastics indicator when in an upward trending market, the price will close near the high, whereas, in a downward trending market, the prices will close near lows.
The stochastic indicator strategy is useful and effective in long trading ranges with a slow-moving trend.
A stochastic indicator is studied during the fast markets. A combination of moving averages, RSI, and more can be used to perform slow stochastics for slow markets.
Stochastics also gives out false signals, which traders should be aware of. It is always good to combine charting tools like Fibonacci retracement to stay with the trend.
Traders should observe the strong trend in the overbought and oversold zones instead of hurriedly buying or selling.
Oversold territory is below 20, and overbought territory is beyond 80.
Always watch for trends because stochastic is not reliable when the price of the asset you are studying lacks trend.
Find the overbought and oversold levels to observe their momentum. You can perform long and short positions when the price continues to stay in the trend and a single direction.
Always find divergences because it is a sign that a potential reversal can take place eventually.
Stochastic oscillators should combine with MACD as well to find divergences.