A stochastics oscillator is a momentum indicator that compares a security’s closing price to a range of its prices over a given time period. The oscillator’s sensitivity to market movements can be reduced by adjusting the time period or by taking a moving average of the result. It generates overbought and oversold trading signals with a 0-100 value range.
So, In today’s blog, let us discuss some trading strategies using stochastic indicator:
What is Stochastic Technical Indicator?
The stochastic oscillator, invented by George Lane in the 1970s, is a type of momentum indicator. The indicator is primarily used to determine whether the price has entered an overbought or oversold zone.
Over a given time period, the Stochastic Oscillator compares where the price closed relative to the price range. The Stochastic Oscillator is represented by two lines, the main line “%K” and the second line “%D,” which represents a moving average of %K.
How do you trade with this Indicator?
The stochastic is intended to oscillate between 0 and 100.
- Low levels indicate that the market is oversold, while high levels indicate that the market is overbought.
- A Stochastics Indicator value of 20 or less indicates that the market is oversold. An overbought condition is indicated by a value of 80 or higher.
Keep in mind that the price can often remain in oversold or overbought territory for extended periods of time. Although reversals from oversold and overbought levels are commonly regarded as buy/sell signals, we must remember that these are just assumptions, and this cannot be regarded as a signal for an entry.
1. Divergence Trading Strategy
Divergence is an extremely effective trading concept. Divergences, according to George Lane, the creator of the Stochastic Oscillator, were the best Stochastic strategy of his momentum oscillator. He believed that price momentum frequently reversed prior to an actual price turn, providing important insights to technical traders.
A bullish divergence occurs when prices make a lower low. At the same time, the Stochastic Oscillator makes a higher low, indicating that the downward price momentum is slowing, which often serves as a precursor for price reversals to the upside.
Bearish divergence on a chart occurs when prices make a higher high while the Stochastic Oscillator makes a lower high, indicating that upward price momentum is slowing, which often acts as a catalyst for downward price movement.
In the above example of Hindustan Aeronaut, we have used the Full Slow Stochastic Oscillator (14,3,3), where we can see how both bullish and bearish divergences on the indicator foretold of trend reversals in price.
However, one should keep in mind that divergences appear due to slowing momentum and don’t necessarily indicate a trend reversal. Hence, one should wait for a trendline break on the price chart, as shown above, to take more confirmed entries.
2. RSI Trading Strategy
This Stochastic and RSI trading system consists of three components: a 200-period EMA, a 3-period RSI with 80 as overbought and 20 as oversold levels, and a Stochastic Oscillator (6,3,3) with 70 as overbought and 30 as oversold levels.
Look for long entries only when prices are trading above the 200-period EMA. Wait for the RSI(3) to fall below 20 and the Stochastic to cross above the 30 oversold levels. Then, go long on the next open bar. When the RSI(3) falls below 50 from above, exit the position.
Wait for the RSI to rise above 80 and the Stochastic to cross below the 70 overbought levels. Then, go short on the next open bar. When the RSI(3) crosses above 50 from below, exit the position.
3. MACD Trading Strategy
We use the default MACD(12,26,9) and Fast Stochastic in this MACD Stochastic combination strategy (5,3,3).
We only consider long entries when the MACD value is above the zero line, and the Fast Stochastic (5,3,3) falls below 20 and then rises above it. When the Stochastic Oscillator falls below 50 from above, it is time to exit the position.
Similarly, we only go short when the MACD value is below zero, and the Fast Stochastic(5,3,3) becomes overbought above 80 and then falls below it. When the Stochastic Oscillator rises above 50 from below, one can exit the position.
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Stochastics Scans in StockEdge
You can also use Stochastics scans available in StockEdge that help us to filter out stocks based on specific criteria, as shown below:
Bottomline
In conclusion, traders can gain important insights into market momentum and possible reversal points by using the Stochastics Technical Indicator. Using three different strategies—crossovers, divergence, and overbought/oversold levels—traders can more accurately manage tumultuous markets. Integrating Stochastics can improve trading results and reduce risks with careful research and flexibility.
Frequently Asked Questions (FAQs)
What is Stochastics?
A technical analysis indicator called stochastics is used to gauge a security’s momentum. It does this by comparing the closing price of a securities to its range of prices over a given time period, usually 14 periods.
How does Stochastics work?
Stochastics fluctuate between 0 and 100, signifying oversold circumstances below 20 and overbought circumstances beyond 80. It aids traders in spotting possible continuation patterns or trend reversals.
What are the main components of Stochastics?
The lines with %K and %D are stochastics. %D is a moving average of %K, and %K is the current closing price in relation to the high-low range.
