What is Stochastic?

This indicator developed by George C. Lane in the 1950s compares the closing price to the difference in the same value over a period of time.

Composed of two lines, the first one, blue, is called the numerical stochastic noted ”%K” set by default over 14 periods. It corresponds to the ratio between the last closing price and the range of prices covered by the prices over a given period.

The second line in red is called ”%D” and is calculated on a moving average of stochastic ‘’%K’’ itself, usually 3 periods.

This indicator is limited, which means that it is capped between zone 0 and zone + 100. Above 80, the value is considered overbought, although it must be understood that this is indicative of a strong upward trend. Below 20, the value is considered oversold and here again it must be understood that the downward trend is strong.

Once again, the Stochastic is only an indicator and reaching an overbought or oversold zone does not in any way certify a price reversal.

There are several strategies that can be used with the stochastic indicator.

 

Trading strategy

 

The reading of overbought and oversold areas, with the reading of divergences, gives good results.

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The stochastic is used in different ways, including by the divergences in the overbought and over-sold areas like many other indicators.

 

A signal considered bullish occurs when the two lines cross: the moving average %K crosses the stochastic line downward, or vice versa.

However, as explained above, an indicator may remain for a long time in an overbought / oversold zone. This is why it is often preferable for many traders to wait for a “confirmation of the indicator” to filter the signals and enter the position: we will be particularly careful, during these crosses, that they occur on overbought or oversold areas to validate their reliability.

The position will be entered when the indicator drops below 80 to sell or above 20 to buy.

 

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If we repeat the divergence studied above on Bitcoin, we must wait until the stochastic indicator (%K in blue) crosses its moving average (%D in red) downward and the sales signal is given by the break from the 80 level downward.

 

This indicator, which is very reactive, is volatile because, unlike some of its peers (such as the RSI), it is not calculated on averages but directly on the variation in prices between the highest / lowest reached. This is why the moving average indicator (%D) of the stochastic is added: to filter and simplify its reading.

This indicator is a momentum indicator and therefore measures the speed of prices and not the trend itself.


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