The stochastic indicator is a tool that is developed by George C.Lane. It is in fact a momentum indicator or oscillator that is used to compare the current market price to the high and low of a specific period of time.
The stochastic is made up of 2 lines, %K and %D. Depending on your setting, you can adjust the sensitivity of these 2 lines to suit your plan.
Although 4here are 3 types of stochastic namely full, fast and slow, the fast and slow ones are more commonly used. So let us take a look at both of them.
From the picture above, you can see that there are more crossovers for the fast stochastic which means that it is actually more sensitive than the slower one. However this gives rise to more false signal which is undesirable in trading.
As for the slow stochastic, it is less sensitive and produces lesser false signals as compa2ed to the fast one. Due to its low sensitivity, it will usually signal you to enter a trade after the market has already moved by certain amount.
How to Read the Stochastic?
When the stochastic moves above the 80 level, the market is considered to be overbought and when it moves below the 20 level, the market is considered to be oversold.
However there is one thing you have to take note, when it moves above the 80 level, it does not always mean that the market will reverse. There are times where it will continue to stay above the 80 level and in this situation; it usually indicates that the market is in a strong uptrend.
The important thing to note when reading the stochastic is when the %K crosses above %D after it reaches the oversold level or when the %K crosses below %D after it reaches the overbought level.
How to Use the Stochastic?
There are several ways you can use the stochastic to help you in your trading and below are some of them
1) Entry Signal: It can be a great tool when it comes to giving entry signal. Personally I like to enter my position when the %K crosses the %D and move out of either the overbought or oversold level.
If I am looking to go LONG, I will wait for the stochastic %K to cross above the %D and move above the 20 mark. If I am looking for a SHORT trade, I will wait for the %K to cross below the %D and move below the 80 mark.
2) Exit Signal: The concept for using stochastic to exit my position is about the same as the entry. If I have taken a LONG trade, I will wait for it to move to the overbought zone and exit my position after %K crosses below %D and move below the 80 mark.
3) Reversal Signal: Other than MACD divergence, you can also make use of stochastic divergence to enter a trade. The positive divergence occurs when the market makes lower low while the stochastic make higher low. This is usually an indication that the market is going to reverse up.
The negative divergence occurs when the market makes higher high and the stochastic make lower high. This usually signifies a downward reversal is going to occur.
The above are 3 ways I usually use the stochastic and I hope that you will be able to make full use of its ability to help you in your trading.