What is Stochastic and how to use it for Trading?

The Stochastic Oscillator was created by George C. Lane and introduced to the trading community in the late 1950s. It was one of the first technical indicators used by analysts to provide insight into potential future market direction and is based on the premise that during a market uptrend, prices will remain equal to or above the previous period closing price. Alternatively, in a market downtrend, prices will likely remain equal to or below the previous closing price.
Using a scale to measure the degree of change between prices from one closing period to the next, the Stochastic Oscillator attempts to predict the probability for the continuation of the current direction trend. Traders look for signals generated by the actions of the stochastic lines as viewed on the stochastic scale.
The Stochastic Oscillator consists of two lines - when both lines are included on a price chart, it is referred to as the Full Stochastic. The two lines are:
%K - tracks the current market rate.
%D - "smoothes out" the %K line by calculating and plotting the exchange rate as a moving average - this is also known as the signal line.
  • %K = 100 x (Closing Price - Lowest Price of N Periods)/ (Highest Price of N Periods - Lowest Price of N Periods)
Note that N is usually is set to 14 periods as this represents a large enough sample of data to arrive at a meaningful calculation.
Most systems allow you to modify the number of reporting periods but by doing this, you could alter the effectiveness of the results.
  • %D = 3 Period Moving Average of %K
The calculation to create the %D Stochastic uses the last three valuations of %K to create a three-period moving average of the %K Stochastic. The result is a "smoothed-out" version of %K.
Because %D is a moving average of %K, it is referred to as "Stochastic Slow" as it reacts more slowly to market price changes than %K. As you would expect, %K is also known as "Stochastic Fast".
( Below charts Blue line is %K, Red line is %D )

The Stochastic Oscillator produces three types of signals:
Divergence (strength of trend)
Overbought / Oversold designations
A crossover occurs when the %K line (the fast stochastic) intersects the %D line (the slow stochastic).
Because the %K line reacts more quickly to market changes, it oscillates at a faster rate than the %D line. Under certain conditions, it can catch up to, and cross over, the %D line.
When the %K Stochastic crosses over and moves above the %D Stochastic, the interpretation is that the market rate is gaining at a faster rate than the average represented by the %D Stochastic. This increase in price strength is considered a buy signal.
A sell signal is the result of the %K Stochastic crossing under the %D Stochastic. This is because the faster moving %K line is declining at a faster rate than the overall, downward trend.

Divergence is simply the difference – or the gap – between the %K and %D Stochastic lines.
Because the %K line moves faster than the %D line, the divergence (the gap) between the two stochastics increases as a trend gathers momentum. However, the lines come closer together as momentum wanes in the prelude to a rate reversal.

Once the %K line climbs into the 80 and above region of the stochastic scale, analysts consider this to be an overbought condition. This could lead to a sell-off forcing the price downwards.
When the %K line falls below 20 on the Stochastic scale, the market may now consider the currency pair to be oversold. As a result, traders may start buying thereby lifting the price higher as the market scoops up a "bargain".

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