What is Stochastics : All about Stochastic oscillator

Stochastic refers to an unpredictable process that can statistically be analysed to draw conclusions. The stock market and financial sector are two of the most common uses for stochastic models.The stochastic oscillator is an important part of technical analysis. It can be used to determine price action for an asset such as stock, commodity, or currency.

The stochastic oscillator is the most powerful indicator in technical analysis of stock markets. Here are some details to help you understand what a stochastic oscillator is and how it can improve your trades.

What's the stochastic oscillator?

Dr. George C. Lane created a technical indicator in the 1950s and called it the stochastic oscillator. The stochastic indicator, unlike other technical indicators that follow the price or volume, tracks the momentum of asset prices. Dr. George Lane called it the stochastic oscillator because the indicator measures oscillations in asset prices. This indicator was based on the principle that there is always an increase in momentum before there is a decrease in price.

What is the working principle of the stochastic oscillator?

The stochastic oscillator is a method of comparing a particular asset's closing price with a wide range high and low prices for a period of time. The stochastic oscillator can be calculated using a standard 14-day period. You can adjust the time period to suit your needs. The stochastic indicator's value for any given time period is always between zero and 100.

Formulas for the stochastic oscillator

To calculate the values, the indicator uses the following mathematical formulas.

K Line Formula:

%K = 100 x CP - H14 - L14

Where:

CP = The most recent closing price

L14 = The lowest trading price for the asset during the 14 previous trading sessions

H14 = The highest trading price for the asset during the 14 previous trading sessions

D-line Formula:

D = 100x (H3/L3)

Where:

H3 = The highest trading price for the asset during the 3 previous trading sessions

L3 = The lowest price at which the asset was traded in the 3 previous trading sessions

%K is the slow-moving indicator and %D the fast-moving indicator as measured by the 3-period moving mean of %K.

The stochastic oscillator states that when the market moves up, the asset's value will close at the highest.. The stochastic oscillator value closes near the lowest when the market is moving downward.

The indicator uses both the D line and K line formulas to identify major signals in price charts for an asset. Charting software solutions are extremely robust and can do all the mathematical calculations by themselves.

What does the stochastic olator mean?

This indicator can be used to detect overbought or oversold signals for any asset and thereby enable you to spot price reversals. If the asset's stochastic indicator is greater than 80, it is said to be in the "overbought" region. The asset is considered to be in the territory of oversold if the value is below 20. The indications of overbought or oversold territory should not be considered as definitive evidence of a reversal. They are only clues to future price movements.

Two lines make up the stochastic chart: one shows the actual oscillator value, the other is the 3-day moving mean of the previous line. These lines are linked and create trading signals when the slow-moving stochastic curve crosses the moving average line. When the %K line crosses over the %D line, a stochastic oscillator chart will predict a trend reversal.

Relationship between the stochastic oscillator (RSI), and Relative Strength Index

Another technical indicator, the RSI, is very similar to that of the stochastic indicator. These tools are both price momentum oscillators and are widely used by traders. Traders often combine the RSI and stochastic oscillator to increase the accuracy of a sell or buy signal. Although the objective of both indicators is similar, their underlying theories may differ.

The stochastic oscillator is based on the idea that asset prices tend to close at their highs in market uptrends, and near their lows in market downturns. RSI measures the speed at which an asset's price moves. The RSI is useful in identifying overbought or oversold situations when a market moves in a trend. The stochastic indicator can be more useful when the stock market is moving sideways or choppily.

How to Trade with Stochastic Oscillator

The stochastic oscillator follows the asset's price. This establishes a relationship between its closing price and the range. The stochastic oscillator has been used extensively to predict the market. It is simple to understand and can be easily calculated using modern technical tools.

Learning to forecast the market using stochastic oscillator is a great way to identify potential trades if you want to trade actively. For the following reasons, traders often use stochastic oscillator.

Day trading

Scalping

- Confirmation of purchase/sale

- Confirmation of overbuy/oversell

- Divergence

- Daily swing method using Admiral Pivot

The stochastic oscillator, which assumes momentum precedes prices, compares the asset's closing price to a predetermined price range. You should be alert for divergence and trend reversal signals when building a trading strategy around stochastic oscillator.

If the two lines of the stochastic oscillator charts intersect, it indicates a possible reversal due to a significant shift in daily momentum.

A possible change in the trend can also be indicated by a widening divergence of oscillator and trending line. If a bearish trend makes a new low but the oscillator remains above that price, this could indicate that bear may be losing steam.

While the stochastic oscillator can be a powerful tool for trading, it should be used with caution. If you don't want your trades to be a disaster, avoid making mistakes.

These are two common rookie mistakes traders make:

Avoid taking a position when the market is too oversold. The market can continue to fall and you could end up making costly mistakes.

Consider every divergence as a potential reversal. Sometimes the indicators may point in different directions. However, there is no reversal in reality.

Stochastic oscillators are used by traders in conjunction with other technical trading tools such as the RSI to avoid mistakes. It is a good rule of thumb to trade in the direction of the trend if you cannot confirm a reversal.

Conclusion

The same function as other indicators is the stochastic oscillator. It indicates when asset prices move to overbought and oversold areas.

The stochastic oscillator, which is a great technical indicator, is often used in conjunction with the RSI. It is still an extremely powerful tool, but it is best to not rely on the readings alone. The indicator can produce false signals, which is why this is important. The indicator may produce false trading signals in certain circumstances, such as high market volatility. In these cases, the price movement of an asset might not match that generated by the indicator. It is a smart idea to use the stochastic oscillator in conjunction with other technical indicators, such as the RSI or Moving Average Convergence Divergence.