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Learn How To Use The Stochastic Indicator Step By Step
Learn How To Use The Stochastic Indicator Step By Step
I am always astonished that many traders don’t really understand the indicators they are using. Or, even worse, many traders use their indicators in a wrong way because they have never taken the time to look into it. In this article, I will help you understand the STOCHASTIC indicator in the right way and I will show you what it does and how you can use it in your trading.
What is the Stochastic indicator?
The STOCHASTIC indicator shows us information about momentum and trend strength. As we will see shortly, the indicator analyses price movements and tells us how fast and how strong the price moves.
This is a quote from George Lane, the inventor of the STOCHASTIC indicator:
“Stochastics measures the momentum of price. If you visualize a rocket going up in the airВ вЂ“ before it can turn down, it must slow down. Momentum always changes direction before price.” – George Lane, the developer of the Stochastic indicator
What is momentum?
Before we get into using the Stochastic, we should be clear about what momentum actually is.
Investopedia defines momentum as “TheВ rateВ ofВ accelerationВ ofВ theВ priceВ ofВ aВ security.” viaВ Investopedia
I am always a fan of going into how an indicator analyzes price and without getting too deep into the mathematics, this is how the indicator analyzes price:
The stochastic indicator analyzes a price range over a specific time period or price candles; typical settings for the Stochastic are 5 or 14 periods/price candles. This means that the Stochastic indicator takes the absolute high and the absolute low of that period and compares it to the closing price. We will see how this works with the following two examples and I have chosen a 5 period Stochastic which means that the Stochastic only looks at the last 5 candlesticks.
Example 1: AВ high Stochastic number
When your Stochastic is at a high value, it means that price closed near the top of the range over a certain time period or number of price candles.
The graphic shows that the low was at $60, the high at $100 (range of $40) and price closed almost at the very top at $95. The Stochastic shows 88% which means that price only closed 12% (100% – 88%) from the absolute top.
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How a high Stochastic is calculated:
The lowest low of the 5В candles: $ 60
The highest high of the 5В candles: $ 100
The close of the last candle: $95
The value of the Stochastic indicator: [(95 вЂ“ 60 ) / (100 вЂ“ 60)] * 100 = 88%
You can see, the high Stochastic shows us that price was very strong over the 5В candle period and that the recent candles are pushing higher.
Example 2: AВ low Stochastic number
Conversely, a low Stochastic value indicates that the momentum to the downside is strong. In the graphic we can see that price only closed $5 above the low of the range at $50.
How a high Stochastic is calculated
The lowest low of the 5 candles: $ 50
The highest high of the 5 candles: $ 80
The close of the last candle: $55
The value of the Stochastic indicator: [(55 вЂ“ 50 ) / (80 вЂ“ 50)] * 100 = 17%
The Stochastic of 17% means that priceВ closed only 17% above the low of the range and, thus, the downside momentum is very strong.
Overbought vs Oversold
The misinterpretation of overbought and oversold is one of biggest problems and faults in trading. We’ll now take a look at those expressions and learn why there is nothing like overbought or oversold.
The Stochastic indicator does not show oversold or overbought prices. It shows momentum.
Generally, traders would say that a Stochastic over 80 means that the price is overbought and when the Stochastic is below 20, the price is considered oversold. And what traders then mean is that an oversold market has aВ high chance of going down and vice versa. This is wrong and very dangerous!
As we have seen above, when the Stochastic is above 80 it means that the trend is strong and not, that it is overbought and likely to reverse. A high Stochastic means that the price is able to close near the top and it keeps pushing higher. A trend where the Stochastic stays above 80 for a long time signals that momentum is high and not that you should get ready to short the market.
The image below shows the behavior of the Stochastic within a long uptrend and a downtrend. In both cases, the Stochastic entered вЂњoverboughtвЂќ (above 80), вЂњoversoldвЂќ (below 20) and stayed there for quite some time, while the trends kept on going. Again, the belief that the Stochastic shows oversold/overbought is wrong and you will quickly run into problems when you trade this way. A high Stochastic value shows that the trend has strong momentum and NOT that it is overbought.
The Stochastic signals
Finally, I want to provide the most common signals and ways how traders are using the Stochastic indicator:
- Breakout trading: When you see that the Stochastic is suddenly accelerating into one direction and the two Stochastic bands are widening, then it can signal the start of a new trend. If you can also spot a breakout out of sideways range, even better.
- Trend following: As long as the Stochastic keeps crossed in one direction, it shows that the trend is still valid.
- Strong trends: When the Stochastic is in the oversold/overbought area, don’t fight the trend but try to hold on to your trades and stick with the trend.
- Trend reversals: When the Stochastic is changing the direction and leaves the overbought/oversold areas, it can foreshadow a reversal. As we’ll see, we can also combine the Stochastic with aВ moving average or trendlines nicely.
- Important: when we look for a bullish reversal, we need to see the green Stochastic line to get above the red one and leave the overbought-oversold area.
- Divergences: As with every momentum indicator, divergences can also be a very important signal here to show potential trend reversals, or at least the end of a trend.
Combining the Stochastic with other tools
As with any other trading concept or tool, you should not use the Stochastic indicator by itself. To receive meaningful signals and improve the quality of your trades, you can combine the Stochastic indicator with those 3 tools:
- Moving averages: Moving averages can be a great addition here and they act as filters for your signals. Always trade in the direction of your moving averages and as long as price is above the moving average, only look for longs – and vice versa.
- Price formations: As breakout or reversal trader, you should look for wedges, triangles and rectangles. When price breaks such a formation with an accelerating Stochastic, it can potentially signal a successful breakout.
- Trendline: Especially Stochastic divergence or Stochastic reversal can be traded nicely with trendlines. You need to find an established trend with a valid trendline and then wait for price to break it with the confirmation of your Stochastic.
Recap: How to use the Stochastic indicator
You might not need the Stochastic indicator when you are able to read the momentum of your charts by looking at the candles, but if the Stochastic is the tool of your choice, it certainly does not hurt to have it on your charts (this goes without a judgment whether the Stochastic is useful or not).
More importantly, this article is meant to make you realize how little you might know about the tools you use for your trading. Additionally, there is a lot of wrong knowledge being shared among traders and even widely used tools such as the Stochastic indicator is often misinterpreted by the majority of traders. Do not blindly believe what other people tell you, do your own research and build your trading knowledge.
Trading with Stochastic indicator involves the following signals:
Stochastic lines cross — indicates trend change.
Stochastic readings above 80 level — currency pair is overbought,
Stochastic staying above 80 level — uptrend is running strong.
Stochastic exiting 80 level downwards — expect a correction down or beginning of a downtrend.
Same for readings below 20 level — currency pair is oversold,
staying below 20 — doentrend is running strong,
exiting upwards above 20 — expect an upward correction or a beginning of an uptrend.
The idea behind Stochastic indicator
The main idea behind Stochastic indicator according to its developer, George Lane, lies in the fact that rising price tends to close near its previous highs, and falling price tends to close near its previous lows.
How to interpret Stochastic indicator
Stochastic is a momentum oscillator, which consists of two lines: %K — fast line, and %D — slow line. Stochastic is plotted on the scale between 1 and 100.
There are also so called «trigger levels» that are added to the Stochastic chart at 20 and 80 levels. Those lines suggest when the market is oversold or overbought once Stochastic lines pass over them.
How to trade with Stochastic indicator
Let’s look at three methods of trading with Stochastic indicator.
Method 1. Trading Stochastic lines crossover
This is the simplest and common method of reading signals from Stochastic lines as they cross each other. Stochastic %K and %D line work similar to moving averages and:
when %K line from above crosses %D line downwards traders open Sell orders.
when %K line from below crosses %D line upwards traders open Buy orders.
Stochastic lines crossovers that happen above 80% level and below 20% level are treated as strongest signals, compare to crossovers outside those levels.
Traders may choose sensitivity of their Stochastics. The smaller the Stochastic parameters, the faster it will react to market changes, the more crossovers will be shown.
Sensitive Stochastic (for example 5, 3, 3) is useful for observing rapidly changing market trends. But because it is too choppy it should be traded in combination with other indicators to filter out Stochastic signals.
Method 2. Trading Stochastic oversold/overbought zones
Stochastic by default has 80% level, above which market is treated as overbought, and 20% level, below which market is considered oversold.
It is important to remember that while in sideways moving market a single Stochastic lines crossover that occur above 80% or below 20% will most of the time result in a fast predictable trend change, in trending market could mean just nothing. When price is trending well, Stochastic lines may easily remain in overbought/oversold zone for a long period of time while crossing there multiple times.
That’s why a method of trading overbought/oversold zones stands up. The rules here are to wait until Stochastic lines after being in overbought/oversold zone come out from it. E.g. When stochastic was trading for some time in overbought zone – above 80% level, traders wait for the lines to slide down and eventually cross 80% level downwards before considering to take Short positions. Opposite for Long positions: wait till Stochastic lines come into the oversold zone (below 20% level); wait further until Stochastic lines eventually cross 20% level upwards; initiate a buy order once Stochastic lines are firmly set, e.g. a trading bar is closed and Stochastic lines cross over 20% mark is fixed.
Method 3. Trading Stochastic divergence
Traders are looking for a divergence between Stochastic and the price itself. At times when the price is making new lows while Stochastic produces higher lows creates dissonance in the picture. It is called divergence. Divergence between price and Stochastic readings suggest a forming weakness of a main trend and therefore its possible correction.
Full versus Fast versus Slow stochastic
Full Stochastic inidcator has 3 parameters, like: Full Stoch (14, 3, 3), where the first and the last parameters are identical to those found in Fast and Slow Stochastic:
the first parameter is used to calculate %K line, while the last parameter represents the number of periods to define %D — signaling line.
The difference between Full and other Stochastics lies in the second parameter, which is made to add smoothing qualities for %K line. Applying this smoothing factor allows Full Stochastic be a bit more flexible for chart analysis.
Table of Contents
Developed by Tushar Chande and Stanley Kroll, StochRSI is an oscillator that measures the level of RSI relative to its high-low range over a set time period. StochRSI applies the Stochastics formula to RSI values, rather than price values, making it an indicator of an indicator. The result is an oscillator that fluctuates between 0 and 1.
In their 1994 book, The New Technical Trader, Chande and Kroll explain that RSI can oscillate between 80 and 20 for extended periods without reaching extreme levels. Notice that 80 and 20 are used for overbought and oversold instead of the more traditional 70 and 30. Traders looking to enter a stock based on an overbought or oversold reading in RSI might find themselves continuously on the sidelines. Chande and Kroll developed StochRSI to increase sensitivity and generate more overbought/oversold signals.
StochRSI measures the value of RSI relative to its high/low range over a set number of periods. The number of periods used to calculate StochRSI is transferred to RSI in the formula. For example, 14-day StochRSI would use the current value of 14-day RSI and the 14-day high-low range for 14-day RSI.
Click here for an Excel Spreadsheet showing the start of a StochRSI calculation.
It is important to remember that StochRSI is an indicator of an indicator, which makes it the second derivative of price. This means it is two steps (formulas) removed from the price of the underlying security. Price has undergone two changes to become StochRSI. Converting prices to RSI is one change. Converting RSI to the Stochastic Oscillator is the second change. This is why the end product (StochRSI) looks much different than the original (price).
StochRSI has characteristics similar to most bound momentum oscillators. First, it can be used to identify overbought or oversold conditions. A move above .80 is considered overbought, while a move below .20 is considered oversold. Second, it can be used to identify the short-term trend. As a bound oscillator, the centerline is at .50. StochRSI reflects an uptrend when consistently above .50 and a downtrend when consistently below .50. Because this indicator is quite volatile, some smoothing with a moving average can help for short-term trend identification.
Trend identification is the key to successfully choosing between overbought and oversold levels. It is important to look for oversold conditions when the bigger trend is up and overbought conditions when the bigger trend is down. In other words, look for trades in the direction of the bigger trend. 14-day StochRSI would be considered a short-term indicator. Therefore, it is important to identify the medium-term trend when looking for overbought and oversold conditions.
Chart 2 shows Boeing in a medium-term uptrend with StochRSI(14) becoming oversold in January and February. First, the medium-term was deemed up because the 10-day SMA was above the 60-day SMA. With an uptrend in place, oversold conditions were preferred to overbought conditions. StochRSI became oversold at least four times from December to February. For what it’s worth, 14-day RSI did not become oversold during this timeframe because it is less sensitive. However, oversold is not the same thing as bullish; oversold conditions instead serve as a warning to watch for a bounce. A catalyst is still needed to solidify the low and signal an actual upturn. In this example, chartists could look for prices to break above the 10-day SMA or for StochRSI to break above .50, its centerline.
Chart 3 shows Flour Corp (FLR) within a downtrend and StochRSI registering overbought readings. First, the medium-term trend is down because the 10-day SMA is below the 60-day SMA. This means oversold readings are ignored and overbought readings become the focus. StochRSI moved above .80 in mid-October and early November (red arrows). These overbought readings suggested that the oversold bounce could end soon. Confirmation came when StochRSI moved back below .50 (red dotted lines). Chartists could also look for the stock to break back below its 10-day SMA to signal a short-term downturn.
StochRSI is quite a volatile oscillator that frequently becomes overbought and oversold. For short-term trend identification, it can help to lengthen the calculation period and apply a short moving average to smooth the data. Momentum favors rising prices when the 10-day SMA of StochRSI is above .50 and falling prices when below .50. Chart 4 shows Chevron (CVX) with 20-day StochRSI and a 5-day SMA of the indicator. The 5-day SMA moved above .50 in mid-February just after the stock gapped higher. The gap and moving average cross above .50 were short-term bullish signals. A falling flag/wedge formed in late February. Notice how CVX found support in the gap zone. The uptrend continued with a flag/wedge breakout and the stock advanced above 80. Even though StochRSI dipped below .50 in late March, the 5-day SMA held above .50 to keep the uptrend alive until late April. This short-term signal turned into a two-month uptrend.
Unfortunately, not all signals are this picture perfect. There will be whipsaws, even when using a 5-day SMA with 20-day StochRSI. For example, a consolidation during a trend can cause the 5-day SMA of StochRSI to gyrate above/below the .50 line before continuing or reversing the trend. Chart 5 shows Yahoo! with 20-day StochRSI and its 5-day SMA for smoothing. The moving average broke above .50 in mid-February to turn momentum bullish. This was followed by a resistance breakout for Yahoo! on the first day of March. As the stock consolidated with a falling channel in late March, the 5-day SMA for StochRSI(20) dipped below .50 twice (red oval). These dips proved short-lived as the stock broke channel resistance and StochRSI moved above .80 to show strength. The trend did not end until the 5-day SMA moved below .50 AND Yahoo! gapped down.
Chart 6 shows Yahoo! with a bearish signal from StochRSI that did not take hold right away. The 5-day SMA for 20-day StochRSI moved below .50 to turn momentum bearish the second week of October. Yahoo! broke support for confirmation, but this break did not hold as the stock surged to 18 a few days later. The immediate recovery and bounce back above 17 formed a bear trap. Even though Yahoo! surged, the 5-day SMA for StochRSI remained below .50 and momentum did not confirm. The subsequent gap above 17.50 turned out to be an exhaustion gap as Yahoo! failed at resistance (18), filled the gap, broke support again and moved sharply lower into November. Talk about volatility.
StochRSI is like RSI on steroids. RSI produces relatively fewer signals and StochRSI dramatically increases the signal count. There will be more overbought/oversold readings, more centerline crosses, more good signals and more bad signals. Speed comes at a price. This means it is important to use StochRSI with other aspects of technical analysis for confirmation. The examples above use gaps, support/resistance breaks, and price patterns to confirm StochRSI signals. Chartists can also employ other complementary indicators, such as On Balance Volume (OBV) or the Accumulation Distribution Line. These volume-based indicators do not overlap with momentum oscillators. Chartists should also experiment with various settings and learn the nuances of StochRSI before using it in the real world.
Using with SharpCharts
The StochRSI indicator can be charted as an indicator using the SharpCharts tool. The “parameters” value specifies the number of periods used in the calculation (default is 14). The indicator can be set above, below or behind the underlying price plot. A moving average can be applied by clicking the advanced options arrow (green) and adding an overlay. Click here to see a live example of StochRSI.
Oversold StochRSI in medium-term uptrend
This scan starts with stocks that have an average price of $10 or greater over the last three months and average volume greater than 40,000. The first filter selects securities within a medium-term uptrend by looking for those where the 10-day SMA is greater than the 60-day SMA. The screen then selects stocks that are short-term oversold by looking for those trading below their 10-day SMA and with StochRSI(14) below .10. This scan often returns many stocks and further refinement may be needed.
Overbought StochRSI within a medium-term downtrend
This scan starts with stocks that have an average price of $10 or greater over the last three months and average volume greater than 40,000. The first filter selects securities within a medium-term downtrend by looking for those where the 10-day SMA is less than the 60-day SMA. The screen then selects stocks that are short-term overbought by looking for those trading above their 10-day SMA and with StochRSI(14) above .90. This scan often returns many stocks and further refinement may be needed.
For more details on the syntax to use for StochRSI scans, please see our Scan Syntax Reference in the Support Center.
Constance Brown’s Technical Analysis for the Trading Professional takes our exploration of RSI to the next level with bull market and bear market ranges, positive and negative reversals, and projections based on RSI. Some methods of Andrew Cardwell, her RSI mentor, are also explained and refined in this book.
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