stochastic indicator explained – Trading Tutorial

Technical analysis is no longer conceivable without the use of software. The focus is usually on indicators. One of the original indicators is stochastics. Stochastics can be interpreted and used in many ways. There are criteria which should be considered absolutely with the use.

Stochastics: Application in all scientific areas

The mathematical principle of stochastics is used by many traders and analysts in virtually every market and environment. It is a combination of statistics and probability theory. The indicator was developed by Dr. George C. Lane. He introduced the idea to a broad public in a scientific article in 1984. The stochastic indicator is a hybrid between the well-known RSI indicator and a momentum indicator. Mathematically, the current closing price is set in relation to the high and low of a defined trading period. With the stochastics, the position of the price can be placed within the fluctuation range. If the price changes up or down, it leaves its typical fluctuation range. Buy or sell signals are generated.

There are two variants of the stochastic. The Stochastic Fast is the original indicator. As the name describes, the indicator is very responsive. There are many entry and exit signals. For the trading practice, there are too many.

What could be more obvious than creating a smoothed variant of the stochastic? It is called stochastic slow. For comparison, the Stochastics Fast and Slow are placed next to each other in the lower picture. In the lower part of the picture they are placed directly next to each other.

The majority of traders use the Stochastic Slow. But if you put Fast and Slow next to each other, the indicator movements harmonize. The respective crossing can be used as an entry or exit signal.

Typical interpretation of the stochastic

The stochastic fluctuates between 0 and 100, with the 50 midline separating the bullish from bearish areas. A value of 100 means that the current price corresponds to the highest value of the observation period. Values above 80 are considered overbought, and below 20 are oversold.

Divergences within the stochastic slow and the underlying are of great interest. A bullish divergence is particularly effective if the first turning point of a stochastic divergence is below 20. With a short signal, the first inflection point is above 80.

n the upper chart, five divergences have been marked. The divergences Div1, Div2, Div3 and Div5 each have their starting point at the extreme (above 80 or below 20). The divergence Div4 lies in the middle of the indicator. In this case, the high of the bearish divergence is only 65, which would still have resulted in a small profit trade. In general, however, stochastic divergences with an initial high of over 80 or an initial low of under 20 have a higher chance of winning.

Caution with trends

The comparison between stochastic and price trends is also of statistical importance. Often the stochastic shows a divergence, and the reversal point is not yet visible in the price trend. In the picture above there are two examples with Div1 and Div5. The divergence is not yet visible in the price trend. This means that the stochastic can be used here as an early indicator for the price trend.

In principle, the hit rate of a stochastic divergence increases if the reversal movement within the price trend is also visible. In order to avoid mistakes, one should absolutely pay attention to the trend strength of the price. As soon as a persistent trend is formed, divergences only have a weak effect as an inversion signal. Therefore, it should be considered whether possible divergences should be ignored as a counter-trend signal in the case of strong trends.

The trick with the kink

The combination of fast and slow stochastics brings advantages. But not every signal is valuable. Perhaps even the majority is rather weak. But if there is a tradable price wave, you can be sure that the stochastic will also provide a signal.

A special stochastic pattern can be used to reduce errors.

Entry setup for a long trade:

(1) The stochastic slow comes from the extreme range below 20.

(2) When the stochastic fast crosses the stochastic slow bullish for the first time, the entry mode is activated.

(3) Afterwards, wait until the Stochastic Fast falls back below Stochastic Slow. It is only an apparent short signal.

(4) If the Stochastic Fast crosses the Stochastic Slow again with a bullish signal, it is a strong signal. Optically, the Stochastic Fast creates a small bend.

The upper chart shows the entry signals (both long and short). It is important to note that each signal also creates a divergence signal. The divergences are part of the kink trick and increase the effectiveness.

The exit from the market

Of course you can also get out of a trade with the stochastic indicator. Opposite indicator crossings always exist. However, many traders complain that the exit signals come too quickly. With the effect that the typical average profit is rather small. Especially in sideways markets, there are many random price movements that generate an exit signal. In the trader performance this is noticeable with frequent trading costs.

It should be considered whether the market itself should not give the exit signal. For example, in a long trade, you can look for a resistance level at which the price would be stuck. Fibonacci relations are also very good. Price targets can be found both via Fibonacci retracements and Fibonacci extensions. In the case of extensions, Fibonacci values of 100%, 161% and 200% are very important. Retracements with 100% or 161% are also effective. Resistances or supports or Fibonacci price targets are not influenced by period settings. Therefore they do not need to be adjusted. This is authentic and practical.

Conclusion on Stochastics

Stochastics is a flexible indicator that provides clear entry and exit signals. Regardless of the setting you choose, you should fully rely on the indicator when trading. If the stochastic is used, then it is unlikely to be used as a trading filter or as a “second opinion” for another system. This only leads to uncertain trading decisions. Concretely: If you are enthusiastic about the stochastic, then you also implement the signals. Otherwise, you’d better leave it alone.

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