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The stochastic oscillator, also known as the stochastic indicator, is a popular trading indicator that is useful for predicting trend reversals. It also focuses on price momentum and can be used to identify overbought and oversold levels in stocks, indices, currencies and many other investment assets.
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The stochastic oscillator measures the speed of price movements. Momentum is the rate of acceleration in price movement. The idea behind the stochastic indicator is that the momentum of an instrument’s price will often change before the instrument’s price movement actually changes direction. As a result, the indicator can be used to predict trend reversals.
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The stochastic indicator can be used by experienced traders and those learning technical analysis. With the help of other technical analysis tools such as moving averages, trend lines and support and resistance levels, the stochastic oscillator can help improve trading accuracy and identify profitable entry and exit points.
The indicator works by focusing on the location of an instrument’s closing price relative to the price’s high-low range over a certain number of previous periods. Normally 14 previous periods are used. By comparing the closing price with previous price movements, the indicator tries to predict price turning points.
The stochastic indicator is a two-line indicator that can be applied to any chart. It fluctuates between 0 and 100. The indicator shows how the current price compares to the highest and lowest price levels during a predetermined previous period. The previous period usually consists of 14 individual periods. For example, on a weekly chart, this will be 14 weeks. On an hourly chart this will be 14 hours.
When the stochastic indicator is used, a white line appears below the chart. This white line is the %K line. There will also be a red line on the chart, which is the three-period moving average of %K. This is called %D.
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This example compares closing price with price range over a given time period to identify overbought and oversold situations.
This momentum indicator works on the basic assumptions that in an uptrend, today’s closing price is likely to be close to the highest recent closing price, and that in a downtrend, today’s closing price is likely to be close to the lowest recent closing price.
Stochastic oscillators show two lines: %K and %D. The %K row compares the lowest low and the highest high for a given period to define a price range, then displays the last closing price as a percentage of that range. The %D line is a moving average of %K.
These two lines are shown on a scale of 1 to 100 with important trigger levels shown at 20 and 80. These lines are represented by a blue and an orange line. Any action outside these lines is considered particularly significant.
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A stochastic study is useful when monitoring fast markets. However, its speed means that it should be used in conjunction with other indicators to confirm any signals, such as a stochastic RSI. If you want a more conservative equivalent, use the slow stochastic.
As with moving averages, when the two stochastic lines (%K and %D) cross, a signal is generated. If the white %K line crosses below the red %D line, a possible sell signal is generated. If the red %D line crosses below the white %K line, a possible buy signal is generated. These crossings can occur anywhere in the study, but signals above the lines at 20 and 80 are considered stronger.
When the stochastic %K line crosses the 80 line, the product is considered overbought. When it crosses the 20 mark, the product is considered oversold. However, in a strongly trending market, the line may remain in this region for some time, so some traders consider the line moving back out of this zone as confirmation of the end of a trend.
In a basic overbought/oversold strategy, traders can use the stochastic indicator to identify trade exit and entry points.
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Generally, traders look to enter a buy trade when an instrument is oversold. A buy signal is often given when the stochastic indicator has been below 20 and then rises above 20. However, traders look to enter a sell trade when an instrument is overbought. A sell signal is often given when the stochastic indicator has been above 80 and then falls below 80.
But overbought and oversold labels can be misleading. An instrument will not necessarily decline in price just because it is overbought. Similarly, an instrument will not automatically increase in price just because it is oversold. Overbought and oversold simply mean that the price is trading near the top or bottom of the range. These conditions can last a while.
Another popular trading strategy that uses the stochastic indicator is a divergence strategy. In this strategy, traders will see if an instrument’s price makes new highs or lows, while the stochastic indicator does not. This may signal that the trend may be about to reverse.
A bullish divergence occurs when an instrument’s price makes a lower low, but the stochastic indicator touches a higher low. This signals that selling pressure has eased and a reversal to the upside may be on the way. A bearish divergence occurs when an instrument’s price makes a higher high, but the stochastic indicator reaches a lower high. This signals that upward momentum has slowed and a downward reversal may be about to take place.
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An important point in relation to the divergence strategy is that trades should not be made until the divergence is confirmed by an actual reversal in price. An instrument’s price can continue to rise or fall for a long time, even when deviations occur.
The stochastic crossover is another popular strategy used by traders. This occurs when the two lines cross in an overbought or oversold region.
When a rising %K line crosses above the %D line in an oversold region, it generates a buy signal. When a declining %K line crosses below the %D line in an overbought region, this is a sell signal. These signals tend to be more reliable in a market with ranges. They are less reliable in a trending market.
In a trend following strategy, traders will monitor the stochastic indicator to ensure that it remains crossed in one direction. This shows that the trend is still valid.
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Finally, another popular use of the stochastic indicator is to identify bull and bear trade setups. A bull trade setup occurs when the stochastic indicator makes a higher high, but the price of the instrument makes a lower high. This indicates that momentum is increasing and the price of the instrument may move higher. Forex traders often look to buy after a brief dip where the stochastic indicator has dipped below 50 on the pullback and then moved up again. A bear trade setup occurs when the stochastic indicator makes a lower low, but the price of the instrument makes a higher low. This signals that selling pressure is increasing and that the instrument’s price may be lower. Traders often look to sell after a brief rise in price.
Traders should be aware that the stochastic indicator has limitations. It is not a foolproof technical analysis tool. The indicator can often generate false signals. In choppy market conditions, this can happen often.
In conclusion, the stochastic indicator is a useful technical analysis tool that can be used to identify overbought and oversold instruments. When combined with other indicators, the stochastic indicator can help a trader identify trend reversals, support and resistance levels, and potential entry and exit points. Price formations such as wedges and triangles and trend lines also work well with stochastic indicators. For example, the trader can monitor an established trend with a valid trend line and wait until the price breaks the trend with confirmation from the stochastic indicator. Brokerage services in your country are provided by Liteforex (Europe) LTD Company (regulated by CySEC License No. 093/08).
To access all programs and services, visit the company’s official website at https://www.liteforex.eu.
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In this article you will find the most comprehensive overview of the stochastic oscillator. We will cover its structure, signals and compatibility with other instruments. In addition, we will test stochastic trading strategies in practice.
Key Tips The article provides an in-depth analysis of the Stochastic Oscillator, a momentum indicator used in the financial markets. Key parameters of the oscillator include %K, %D and a smoothing coefficient, with common settings 5, 3 and 3. The Stochastic Oscillator has three versions of settings, such as fast, slow and full. These versions interact differently with market noise. Time frames and chart types also affect oscillator performance. The article emphasizes the importance of crossings between the %K and %D lines and understanding
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