The stochastic is an oscillator used in stock market analysis. It follows the relationship between each closing price and the recent range of maximums and minimums. The stochastic measures the high or low capacity to close the quotation price near its maximum or minimum of the day. When prices go up, they tend to close close close to their upper limit and vice versa when they go down.
What is the stochastic indicator?
It is an indicator developed by George Lane consisting of two lines known as %K and %D. It is based on the fact that when prices go up, the closing price is closer to the maximums of the day, and when prices go down, the closing price is closer to the minimums of the session.
The stochastic sets the percentage on how the closing price of the session is in relation to the price range of the calculation period (either a daily range, 5 days…)
What is it for?
The functionality of stochastic is seen when the values are not in strong trends. It is used to determine the various zigzags in which prices move, and to provide buying and selling signals.
The stochastic is a standardized indicator that moves within a scale of 0 to 100 and has two areas or levels that become particularly important when they are hit by the indicator. We consider that the stochastic is indicating that:
The asset is overvalued if the stochastic lines (%K, %D) ese are in the zone between 0 and 20.
The asset is overbought if the stochastic lines are in the area between 80 and 100.
The signs of trend change given by the stochastic are stronger if the stochastic is in the overbought or oversold zone.
These areas marked on the stochastic also mark the overbought and over sold zones respectively.
How to use the indicator?
The default parameters used in the classic stochastic indicator are 14 for %K and 7 for %D, 14 being the period in days taken as reference for the calculations and 7 for calculating the slatted version of %K. Another version known as Slow Stochastic is also used, which uses 3 parameters, the latter being a new smoothing applied to the lines, the default value of which is generally 3. Stochastic generally uses a moving average of 5 days for %K and a moving average of 3 days for %D.
Strategies with stochastic indicators
The stochastic provides a buying signal when the %K line is cut above %D in the oversold zone 0-20(30).
Stochastic provides a sales signal when there is a cut in the %K line below %D in the over-sold zone (70) 80-100.
The line cuts mark a change in price direction, the problem is that it is not possible to quantify the range of movement.
Strategies with divergences in stochastic indices
When there is a high divergence, buy and put a protection stop below the last minimum price.
When a low divergence is detected, sell short and put a protection stop above the last maximum.
Trading Suggestion with stochastic indicator
If the market is on trend, you should use the indicator crosses outside the overbought and oversold areas to increase the positions in the trend direction.
In a market with a strong uptrend, increase long positions (upwards) whenever the %K line is above %D.
In a market with a strong downtrend, increase short positions (down) each time the %K line is below %D.
This pyramidal strategy with the stochastic will substantially increase profits on the winning positions, that is, you have to be very strict with the stop loss