Traders use technical indicators to help them identify the best times and prices to buy or sell assets. One of the most popular indicators is the Stochastic, developed in the 1950s by George Lane. This indicator looks for reversal points in an asset’s momentum, and if you know how to interpret its signals, it can lead to profitable trades.
The Stochastic oscillator consists of two lines that appear on the price chart of your chosen instrument. The slower %K line is called the main or slow stochastic, and the faster %D line is known as the signal line. The %D line is calculated as a 3-period simple moving average of %K, and traders watch for the crossings between the signal line and %K to determine changes in the direction of momentum. When the signal line crosses above %K, it’s said that the price may be about to move up, and when it crosses below %K, it suggests that the price is about to fall.
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How does it work?
The indicator compares a current closing price with the high and low range over a specific number of past periods (usually 14). It’s this method that differentiates it from other similar tools, like trendlines and support and resistance levels. In calculating the stochastic, the mathematical formulas used focus on a particular closing price and a range of high and low prices that have been seen over a period of time.
Once the calculation is complete, the %K and %D lines are displayed on a graph in order to highlight changes. In general, a %K value that is above 80 is considered overbought and below 20 is oversold. The signal line is the difference between %K and %D, and it’s the crossing of this line that indicates the signal to buy or sell.
Divergences
As with other trading indicators, the Stochastic oscillator can sometimes generate false trading signals. To reduce this risk, some traders take a more conservative approach and only consider overbought and oversold conditions when the reading is above or below 80. In this way, they limit the potential for false signals and make sure to have a solid trading strategy before trading. In addition to this, you should also always look out for divergences between the price and the Stochastic oscillator. For example, if the price makes a higher low while the Stochastic Oscillator produces a lower low, it’s called a bullish divergence and could indicate a good turning point.