Stochastic oscillator: Explanation and Trading Strategies
The stochastic oscillator is a popular technical analysis indicator that can be used to produce efficient and profitable trading signals. In this article, we'll let you know how to calculate it, how to use it for trading cryptocurrencies and how to combine it with other technical analysis indicators to generate more profitable trading signals.
The History of the Stochastic Oscillator
The Stochastic Oscillator is a widely used momentum indicator, developed by George C. Lane in the late 1950s. Lane's primary goal was to create a tool that could measure the speed or momentum of price changes and help traders identify potential trend reversals in various markets, including the cryptocurrency market. The Stochastic Oscillator quickly gained popularity among traders due to its simplicity and effectiveness in measuring overbought and oversold market conditions. Since its inception, the Stochastic Oscillator has become a staple in technical analysis, providing traders with valuable insights into market momentum and potential trend reversal points.
What is the stochastic oscillator?
The stochastic oscillator is a momentum indicator that measures the rate of change of price. It is used to identify overbought and oversold conditions in the market, as well as to generate buy and sell signals. The stochastic oscillator can be used on any time frame, but it is most commonly used on daily or weekly charts. It is made up of two lines, %K and %D, that fluctuate between 0 and 100. %K is the main line and is a measure of the current price compared to the previous closing prices. %D is the signal line which is usually a 3-period Simple Moving Average of %K.
On this picture, the stochastic oscillator is below the candlestick chart. The %K line is in blue and the %D line is in yellow. You can see that the %D line trails behind the %K line.
How to calculate the stochastic oscillator?
The stochastic oscillator is calculated using the following formulas:
%K = 100(C – Ln)/(Hn – Ln) |
Where:
- C = the closing price of the security
- Ln = the low price of the security over the past n periods (usually 14)
- Hn = the high price of the security over the past n periods (usually 14)
A smoothing period is sometimes applied to %K, prior to the calculation of %D. This means computing a Simple Moving Average of %K before calculating %D.
What trading signals does the Stochastic oscillator give?
The stochastic oscillator can be used to trade any cryptocurrency, but it works best on those with high liquidity and large trading volumes.
The stochastic oscillator can generate the following signals:
- Overbought signal: when the stochastic oscillator is above 80, it is considered to be overbought and a sell signal is generated.
- Oversold signal: when the stochastic oscillator is below 20, it is considered to be oversold and a buy signal is generated.
- Divergence: when the price of the security diverges from the stochastic oscillator, it is a sign that the current trend is about to reverse.
- Bullish and bearish cross: whenever the %K line crosses the %D line from below in the low-range values, it can be interpreted as a buy signal. Conversely, when the %K line crosses the %D line from above in the high-range values, it can be interpreted as a sell signal.
The picture above is drawn from Binance's BTC/BUSD spot market. Both the %K line and the %D line are below 20 on the left circle, giving an oversold signal. Then, the %K line crosses below the %D line, giving a bearish cross signal.
What other indicators can be used with the stochastic oscillator?
The stochastic oscillator can be used with other technical indicators to generate more accurate trading signals. Some of the most popular indicators to use with stochastic are the moving average convergence divergence (MACD) and the relative strength index (RSI). These indicators can help confirm stochastic signals and provide additional information about market conditions. Traders also often use the stochastic oscillator in conjunction with support and resistance levels, to generate more accurate trading signals.
How to use the stochastic oscillator with the MACD
The stochastic oscillator can also be used in conjunction with the MACD to generate more accurate trading signals. The MACD is a trend-following indicator that measures the difference between two moving averages. It is used to identify the direction of the market and to generate buy and sell signals. When the stochastic oscillator is used with the MACD, it can help confirm stochastic signals and provide additional information about market conditions. For instance, if the MACD is positive and the stochastic oscillator reaches upwards of 80, it is a strong overbought signal and thus a good time to sell.
How to use the stochastic oscillator with the RSI
The stochastic oscillator can be used in conjunction with the RSI to generate more accurate trading signals. The RSI is another momentum indicator that measures the speed and change of price movements. It is used to identify overbought and oversold conditions in the market, as well as to generate buy and sell signals. When the stochastic oscillator is used with the RSI, it can help confirm stochastic signals and provide additional information about market conditions. For instance, if the RSI is above 70 and the stochastic oscillator reaches upwards of 80, it is a strong overbought signal and thus a good time to sell.
How to use the stochastic oscillator with support and resistance levels
The stochastic oscillator can also be used in conjunction with support and resistance levels to generate more accurate trading signals. Support and resistance levels are price levels where the market has a tendency to reverse direction. They are used to identify potential buy and sell opportunities in the market. When the stochastic oscillator is used with support and resistance levels, it can help confirm stochastic signals and provide additional information about market conditions. For instance, if the stochastic oscillator is overbought and the price is approaching a resistance level, it may be a good time to sell.
Conclusion on the Stochastic Oscillator
In conclusion, the Stochastic Oscillator is an essential tool in the technical analyst's arsenal, offering valuable insights into market momentum and potential trend reversals. By measuring the closing price relative to the high-low range over a specific period, the Stochastic Oscillator helps traders identify overbought and oversold conditions, which can signal possible entry and exit points in the market. When used in conjunction with other technical analysis tools and indicators, the Stochastic Oscillator can improve trading decision-making and risk management in the fast-paced and volatile cryptocurrency market.
Frequently Asked Questions about the Stochastic Oscillator
1. How does the Stochastic Oscillator work?
The Stochastic Oscillator measures the closing price of an asset relative to its price range over a specified period, expressed as a percentage. It consists of two lines – the %K line and the %D line. The %K line represents the main line and is calculated based on the high, low, and closing prices of the asset. The %D line is a moving average of the %K line, which acts as a signal line. When the %K line crosses above or below the %D line, it can generate potential buy or sell signals.
2. How do I interpret overbought and oversold conditions using the Stochastic Oscillator?
The Stochastic Oscillator ranges between 0 and 100. A reading above 80 typically indicates an overbought condition, suggesting that the asset may be overvalued and due for a price correction. Conversely, a reading below 20 signals an oversold condition, implying that the asset may be undervalued and due for a price increase. It is essential to use other technical analysis tools to confirm the signals generated by the Stochastic Oscillator to avoid false breakouts and whipsaws.
3. How can I combine the Stochastic Oscillator with other technical analysis tools for better results?
The Stochastic Oscillator can be used in combination with other technical analysis tools, such as Simple Moving Averages, RSI, MACD, or candlestick patterns, to corroborate signals and filter out false breakouts. For example, traders can use the Stochastic Oscillator in conjunction with trendlines or support and resistance levels to validate potential trend reversals. Additionally, combining the Stochastic Oscillator with other momentum indicators, such as the RSI or MACD, can provide further confirmation of overbought or oversold conditions and improve the overall accuracy of trading signals.
4. Can the Stochastic Oscillator be used on different timeframes?
Yes, the Stochastic Oscillator can be applied to various timeframes, such as hourly, daily, or weekly charts, depending on your trading style and preferences. Short-term traders may find the Stochastic Oscillator more useful on shorter timeframes, like hourly or 15-minute charts, to capture quick price movements. On the other hand, long-term traders might prefer using the Stochastic Oscillator on daily or weekly charts to identify broader market trends and potential trend reversals.