STOCHASTIC is one of the most popular trading tools, and for good reason. The STOCHASTIC is a powerful momentum and trend-following tool. It can help traders understand trend dynamics and improve chart reading.
But I’m always surprised that so many traders do not really understand what they are doing. Or worse, some traders misuse their indicators and make poor trading decisions.
This article will explain the STOCHASTIC indicators and show you how to use them in your trading.
What is the STOCHASTIC Indicator?
The STOCHASTIC indicators give us information on trend strength and momentum. We will soon see that the hand analyzes price movements to tell us how fast the price moves.
Here is a quotation from George Lane, inventor of the STOCHASTIC indicator:
“Stochastics is a way to measure the price’s momentum. Imagine a rocket in the sky. Before it can slow down, it has to go up. “Momentum always changes before price.” George Lane, developer of the Stochastic Indicator
What is Momentum?
We should first understand what momentum is.
Investopedia defines “momentum” as “The rate at which the price of a stock accelerates.” via Investopedia.
I’m always interested in how an indicator analyzes the price and what causes it to go up or down. This will allow us to quickly gain valuable insights into the best use of the hand.
How is the Stochastic calculated?
The stochastic indicators analyze a price range within a period or a set of price candles.
The Stochastic indicator compares the closing price to the highest high or lowest low of the 14 previous candles. It’s as simple as this.
Let’s look at two examples to see how it works.
EXAMPLE 1: A HIGH STOCHASTIC NUMBER
If your Stochastic has a high value, it means the price was near the top of its range for a specific period or over a set number of price candles.
The chart below shows the lows and highs of the 14 most recent candlesticks.
The highest point is 0.6283
The lowest point is 0.6258
The close is at 0.628%
The difference between the high and low is 0.0025 (0.6283-0.6258).
The distance between the closest point and the highest peak is 0.0003 (0,6283-0,628).
Divide 0.003 by 0.025% to find out how close the price is to the absolute highest of the range. Calculation gives us 12%.
The current close is 12 % away from the highest point and 88% (100%-12%) away from the lowest.
The Stochastic is 88 in this example.
The Stochastic indicator tells you, then, how close the price is to the highest high or lowest low of a price range.
Math is not difficult at all.
Check the distance between the highest highs and lowest lows. Then, you need to see how close a price is to the highest or lowest high.
EXAMPLE 2 A Low Stochastic Number
A low Stochastic indicates a strong downward momentum.
In the screenshot below, we can see that the price of the candlesticks has fallen significantly in the last 14 candles. We can also see the current close being relatively close to the absolute lowest. Only a tiny candlestick wick sticks out lower.
By understanding this, we can assume that the Stochastic has to be low. The Stochastic measures the distance between the price and the lowest low.
The Stochastic indicator also shows a value of 13. This indicates that the price is 13 percent away from its lowest low and 87% from its highest high.
Oversold vs. Overbought
Misinterpretation of terms such as overbought or oversold can be a major problem and a mistake in trading. Let’s now look at these expressions to learn why overbought and oversold are not the same thing.
It does not indicate oversold or undersold prices. It is a momentum indicator.
In general, traders will say that when the Stochastic falls below 20, it indicates that the market is oversold. What traders conclude is that a market that has been oversold will have a greater chance of losing and vice versa. This is dangerous and wrong!
As we saw above, when Stochastic is over 80, it indicates that the trend is strong. It does not mean that it will reverse. A high Stochastic means that the price was able to push higher and close at the top. Stochastics that stay above 80 for long periods indicate that the momentum is strong and that it’s not the right time to short the market.
Below is an image that shows how the Stochastic behaves within both a long-term uptrend and downtrend. In both cases, the Stochastic reached “overbought” (above 80) or “oversold” (below 20) and stayed in that state for a long time while the trend continued.
Trading this way will lead to problems. The high Stochastic shows that the trend is strong and NOT ready to reverse.