What is Stochastic?
The Stochastic Oscillator is a technical momentum indicator that compares a closing price to its price range over a given time period. It does not follow price or volume, but momentum of price.
Stochastic is displayed as two lines. The main line is %K, and the second line %D, is a moving average of %K.

To calculate a 10-day %K, this is the formula:
%K = 100[(C-L10)/(H10-L10)]
C = the most recent closing price
L10 = the low of the previous 10 candlesticks
H10 = the high of the previous 10 candlesticks
%D = 3-period moving average of %K

The sensitivity of the lines can be adjusted by setting the time period. By setting a shorter time period, the lines will be more sensitive to market movement.

How to use Stochastic?
There are 3 ways to use Stochastic:
1.    Extreme levels
2.    Crossovers
3.    Divergence

Extreme levels
Stochastic can be used to tell if the market is being overbought or over sold. If the lines are above 80, it means the market is overbought. When the lines are below 20, it means that the market is oversold.

As seen from above, it is a good time to sell when the market is overbought, and it is a good time to buy when the market is oversold.

Stochastic can also produce buy and sell signals when the %K line and %D line intersect each other. When %K crosses below %D, it signals a downtrend. Conversely, when the %K crosses above %D, it signals an uptrend. Traders can buy or sell according to the trend.

%K is represented by the solid green line, while %D is represented by the dotted red line.


Divergence occurs when the indicator does not move in line with the price. For example, when the price reaches a new high and is forming an uptrend, the stochastic starts to form a downtrend. This is a bearish divergence and it signals a trend reversal.
A bullish divergence is the opposite, where the price reaches a new low and is forming a downtrend, while the stochastic forms an uptrend.

The diagram above shows a bearish divergence. Traders should wait for price to break lower and start going short when the trend starts to reverse.

Hope fully you like this chapter on Stochastic!

This was done by a good friend Kelvin Chong!
Next Post »