Stochastics Indicator is a powerful technical analysis tool for trading the markets. Learn how to use it and the best stochastic settings for swing trading and day trading.
The Stochastics Indicator is a well-known and widely used indicator in technical analysis, helping traders maximize profits by making smarter trades. It is based on the observation of current market conditions and helps to identify overbought and oversold areas.
There are lots of technical indicators available for analyzing stocks. Traders use them to strengthen their trading plan. The disadvantage with some of them is that they give buy or sell signal when the price move in the security has already occurred. So, the chance to earn big profit may already have gone. They are the lagging indicators.
Uniqueness of Stochastic lies in the fact that it is a leading indicator. It means it gives the signal much before the move in prices occurs. Moreover, it gives more accurate entry or exit points than other lagging indicators. It generates signal before the move occurs in the stock prices. The traders get early signals for a trade. This enables the traders to maximize their profits.
Learn how to use the stochastics indicator for trading the stocks.
Understand What the Stochastics Indicator Measures
The stochastics indicator measures the momentum of an asset or market. It does this by comparing the closing price to the previous range and indicates whether an asset is overbought or oversold relative to its recent trading range.
By looking at the movements of the stochastics indicator, traders can get a better understanding of whether it is time to buy or sell.
Stochastics was developed by George Lane. Stochastics give a relatively reliable signals for trading. They are really best if you combine them with another one or two technical indicators.
How To Trade Stochastic Oscillator- Pinpoint Entry Zones with the Stochastics Crossover Signal.
The stochastics indicator combines two lines (K and D lines) which can indicate when a reversal or breakout may occur. The K line is used to measure the current price relative to its highest recent high and lowest recent low. On the other hand, the D line is a measure of the average closing prices for a given period.
Buy signals are generated when the K line crosses above the D line, and short signals will be generated when it crosses below. Traders should therefore look out for these crossovers in order to spot potential entry points into a trade.
Stochastic for a security keep fluctuating between 0 – 100 on the technical chart.
It represents if the security is overbought or oversold. Values above 80 represent overbought. Values below 20 represent oversold security and therefore possible reversal in the ongoing trend.
While using stochastic oscillator, we have to look for K line crossover the D line.
When K line crosses below 80 level after crossing above it and also crosses D line in the process, it is a signal to go short for the traders.
Similarly, when the K line crosses above 20 level after crossing below this level and also crosses D line, it is a signal to go Long (see yellow arrows in the figure and corresponding stock moves in the chart above that).
It needs to be remembered that overbought security may not start retracing back immediately. It has the probability of remaining in overbought territory for extended periods of time. Similarly true is for oversold conditions.
So, it becomes imperative to trade in the direction of longer term trend of the market. In bull markets, you can look for oversold security to go long. On the other side, look to go short in overbought situations in a longer bearish trend.
Applying Stochastic as a single indicator to decide for a trade cannot be 100% accurate. It is better if we apply it along with other indicators like relative strength index (RSI) or MACD or moving average convergence divergence indicator.
Stochastic can be more useful if applied along with support and resistance for that stock or security.
Once you have a grasp of the basics, you can employ additional strategies to better monitor price movements. For example, you can use the overbought/oversold levels to identify where there may be longer-term trends in the market.
- When the K line moves into the 70 or higher (overbought) region, this could be an indication that prices are rising and a long position should be taken with caution.
- Similarly, when it moves below 30 (oversold), a short position might be more ideal. Additionally, these readings can provide traders with valuable insight into potential reversals in market sentiment.
Types of Stochastic Oscillators
Stochastic are of two types –
Fast stochastic are more sensitive to price moves. Hence probability of errors can be there in very short-term trading.
Slow stochastic being slow are more useful as being less sensitive. The margin of error is considerably reduced.
So slow stochastic are more popular among the traders when looking to apply stochastic in their trading plan.
Divergences In Stochastics Oscillator- Monitor Divergence Signals to Time Reversals Accurately.
As the Stochastics Indicator moves in and out of the overbought/oversold levels, traders should keep an eye on divergence signals to time reversals accurately.
Whenever prices move towards a new high, yet the K line fails to reach a similar level as the last peak (or vice versa for lows), this could indicate that prices may be ready to reverse directions. If you observe these signals, it may be best to exit your current positions accordingly.
Positive divergence is when the stock price is making new low while the stochastic is making highs after crossing 20 level. It indicates the bullish trend is about to start in the stock. So, the traders need to be positioned on the long side.
See in the above daily candlestick chart, the stock price is in downtrend and moving lower. However, the stochastics are not moving lower but making higher lows. Thus, the price action is in divergence to the stochastics. This tells us that the selling pressure is getting exhausted and stock price may move higher. Keeping the swing low as a stop loss, traders may consider buying the stock. See, how the stocks started moving higher after the positive divergence.
Negative divergence is when the stock is making new highs while the stochastic is making lows after crossing the 80 level. So, traders need to be cautioned or should decide to go short as the stock may start falling.
In this chart with negative divergence, the stock was making higher highs while the stochastics was making lower highs continuously. This set up indicates us that the up trend in stock price is near exhaustion. It is time to exit our long positions and look for short selling the stock.
Stochastics are an essential part of any swing trader’s arsenal. They’re used to help traders determine whether a stock has reached its peak or bottom. Traditionally, stochastics were only used to analyze charts with daily data. However, there are now stochastic tools available for intraday analysis.
Best Stochastic Settings For Swing Trading
Swing trading is short term trading lasting for few days of time frame. A swing trader tries to catch the small or big swings in share prices to earn the profits. Technical indicators are used to get the entry or exit signals for a swing trade.
Stochastic oscillators can be an ideal indicator to get a trading signal for a swing trade. It is important to mention here that you do not rely solely on the stochastics.
Along with a stochastic crossover, you also take a look at the daily candlesticks. Look for any bullish or bearish candlestick pattern.
The above image is an example for TCS stock. The slow stochastic was above 80 or 93 to be more precise when it gave bearish crossover. So the sell signal was generated.
And also if you look the chart carefully, there was a ‘Top’ formation before which the stock tumbled to lower prices.
After the formation of 2 red candles on February 8 and 12, I shorted the stock on February 13. Although the stock saw a spike towards previous highs but it started falling after that.
I bought Put Option on that day. The profits were quadrupled after 3 days. The Option price which I bought at a price of 32 was trading at 141 after 2 days.
That is the power of stochastic crossover to help you make money if it is spotted and executed timely.
The stochastic oscillator settings for swing trading :
%K Periods – 9
%K Slowing – 3
%D Periods – 9
Moving Average – Simple
Stochastic Settings For Day Trading
You can use stochastic settings for day trading also. Same rules apply for day trading also, just like we discussed for swing trading.
For intraday trading, you can use technical charts for various time periods ; Hourly, 30 Minutes, 15 Minutes, 5 minutes or 3 Minutes.
To reduce the noise and avoid false signals, I personally prefer hourly charts for intraday trading.
Use candlestick charts for hourly charts. Look for bullish or bearish pattern formation as we saw the Top formation in previous example.
Stochastic settings for Day Trading :
%K Period – 20
%K Slow – 3
%D Period – 3
These settings work best for me. You can also try these settings. they should work best for you also.