What is a Stochastic Indicator and How Does it Work?

[TL; DR]

🔹 The assumption of stochastic indicators is that prices close near the high of candlesticks during uptrends and on their lows during downtrends.

🔹 Traders can use the overbought and oversold market conditions to time their trade entries and exits.

🔹 The stochastic indicator operates within a range of 0 and 100.

🔹 We buy assets when they are in overbought market conditions and sell them when they are in oversold conditions.






Introduction

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It is common for most traders to use price action alongside indicators. What is essential is to have the right mix of indicators. Many traders use stochastic indicators because they exist on various trading platforms including centralized crypto exchanges such as Gate.io.


What is a Stochastic Indicator?

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The famous technical analyst, George Lane, developed the stochastic indicator based on the assumption that prices close near the high of candlesticks during uptrends and on their lows during downtrends. Therefore, the stochastic indicator indicates the position where the price of an asset closes within a period.

Basically, the stochastic indicator is a tool to measure the momentum of an asset. Momentum refers to the pace at which the price of an asset changes, either negatively or positively. The reason why many traders use the stochastic indicator is that the momentum changes first before the price. As a result, traders take the most appropriate action before the price increases or decreases.

The stochastic indicator serves several functions. First, it shows beforehand that the price of a specific asset is about to change direction, by means of the overbought and oversold market conditions. For example, if the asset is overbought it is likely to experience a downward price reversal. When the asset is oversold, its price will likely experience an upward price reversal.

These market indications help traders to enter or exit trading positions in a way that maximizes their profits. For instance, most traders enter trading positions at the beginning of trends. They go long at the start of an upward trend or short trades at the start of downward trends.

The stochastic indicator operates within a range of 0 to 100 depending on the price changes. If the reading is 80 and above, it shows that the asset is overbought. When the reading is 20 and below it's an indication that the asset is oversold. We also have a midpoint of 50 which helps to gauge the direction the price of an asset would be heading towards at any time.


The above graph shows the major demarcations of the stochastic indicator. As shown in the graph, a stochastic indicator has two lines namely K% and D%. K%, the greenline, is the faster of the two lines while D% is the slower one.

The K% line is a comparison of the highest high and lowest low of a period. It displays the closing price of the period as a percentage of the range. D% is the moving average of K%. Usually, these lines are displayed as green and orange as shown in the diagram. However, the colours may change depending on the platform you are using or your settings.

The action which is below or above these lines is very significant as it indicates the direction the price is most likely to take.


How to calculate the stochastic indicator

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Although most trading platforms have inbuilt stochastic calculation software, let’s illustrate in simple terms how you can derive it. We use the following formula:

%K = 100(C - L14) / (H14 - L14)
C = the most recent closing price
L14 = the lowest price of the 14-day period
H14 = the highest price of the 14-day period
As you realize, the default period is 14 days.


How to trade using stochastic indicator

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There are several ways in which you can use the stochastic indicator, depending on your preferences. The first thing is to use the overbought and oversold market conditions to predict trend reversals as well as entry and exit points.

Oversold means that the price of an asset has decreased beyond the level the market expects under the prevailing conditions. In other words, the asset is undervalued.This is the point where most traders buy assets as they are undervalued and most likely result in high profit.
Generally speaking, if both the K% and D% lines move below the oversold level of 20 it is a buy signal. The exact point where you enter the trade depends on indications from other indicators you use or the asset’s price action.

Overbought is a market situation where the price of an asset is higher than its fair price. Put differently, the asset is overvalued. The graph below shows both overbought and oversold market conditions of an asset.

As you see, at point B the price is close to the 100 line level. Under normal conditions, this is the point where most traders would sell their assets. Generally, when both the K% and D% lines move above the overbought level of 80 it is a sell signal. The exact point where you exit the trade depends on confirmations from other indicators you are using or the asset’s price action.


Stochastic Oscillator Crossover
Other reliable entry and exit signals come from the crossovers of the K% and D% lines. If the K% line crosses above the D% line it is a buy signal. When the K% line crosses below the D% one, it is a sell signal. You can observe these two signals in the graph below.

It is important to note that the crossover signals work best during a range market. In contrast, they are not reliable signals during uptrends and downtrends. Even with the range market, the trader should wait for confirmations.


Bullish and bearish divergences
The stochastic indicator also shows buy and sell signals using divergences. A bullish divergence occurs when the stochastic oscillator shows a higher low while the price shows a lower low. This is an indication that the downward price trend is weakening, showing a possibility of an upward price reversal.

On the contrary a bearish divergence occurs when the price forms higher highs while the stochastic indicator reaches a lower high. This indicates weakening of the upward price momentum and a possible downward price reversal. Even with the bullish and bearish divergences traders should wait for confirmations from other technical indicators or price action.

Bull and bear set-ups
Traders can use stochastic indicators to locate bull and bear set ups. A bull trade setup takes place when the stochastic indicator forms a higher high while the price reaches a lower high. This indicates that the asset’s momentum is increasing, implying that the instrument’s price may rise. A trader can wait for a pullback in order to buy the asset.

A bear trade setup is a situation where the stochastic indicator forms a lower low while the price reaches a higher low. This is an indication that there is an increase in the selling pressure and the price might drop further. The trader may wait for the price to rebound and sell the trade.


How to use stochastic indicator at Gate.io

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It is very simple to use the stochastic indicator at Gate.io. You find the various technical indicators below any chart you are using. Find “Stochastic” below the chart and click on it.


If you click on Stochastic as shown above, it suddenly appears on your chart. From there, you can interpret it the way we have discussed above. In this case, the K% line is in blue while the D% is in orange.


Conclusion

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A stochastic indicator is a technical tool used to measure the price momentum of an investment asset. The price oscillates between 0 and 100 and generates various trade signals in the process. If the K% and D% lines rise above the overbought level of 80 it is a sell signal. Conversely, if the K% and D% lines fall below the oversold level of 20 it is a buy signal.



Author: Mashell C., Gate.io Researcher
This article represents only the views of the researcher and does not constitute any investment suggestions.
Gate.io reserves all rights to this article. Reposting of the article will be permitted provided Gate.io is referenced. In all cases, legal action will be taken due to copyright infringement.