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Momentum Indicators: Stochastics
Discover stochastics, a technical indicator that enables you to identify the end of one trend and the beginning of another. We’ll explain what the stochastic oscillator is, and how you can use it to anticipate market turning points.
Technical Momentum Indicators Explained
Momentum is an aspect of technical analysis. You can visualise how it works if you imagine a ball being throw in the air.
The velocity (or upside momentum) of the ball begins to slow as it nears the peak of its upward trajectory. That means its upside momentum can be in decline even while the ball is still rising, and subsequently before it begins to fall.
The lesson for technical analysis is that momentum can change direction before the price does, making it an indicator of coming change in market direction.
What is the Stochastic Oscillator?
The Stochastic Oscillator is an indicator of momentum in the movement of a price. It compares where the price is trading relative to the price range (high to low) over a given period. The basic premise behind it is that in an uptrend, the price should be closing near the highs of the period trading range, signalling upward momentum.
- In a strong positive market, the bulls should be “winning” the sessions.
- Whereas when the price is in a downtrend, strong bearish momentum should come with the price closing near the lows of the trading range.
Deviations from these rules are considered to be signals.
The Stochastic Oscillator was first developed in 1957 by a group of futures traders led by George C. Lane. Lane contributed significantly to the acceptance and popularity of the stochastic oscillator as a technical indicator.
Fast Stochastics and Slow Stochastics
There are two different types of Stochastic Oscillator: Fast and Slow. The Fast Stochastic Oscillator consists of two lines:
- %K (the Main Line) = is the raw measure used to formulate the idea of momentum behind the oscillator. It is the main Stochastics line and is displayed as a solid line
- %D (the Signal Line) = this is a moving average of %K and is often shown as a dotted line.
| Parameters | |
|---|---|
| Number of periods in the range | 14 |
| Number of periods for %D calculation | 3 |
| Number of periods for Slow Stochastic %D moving average | 3 |
*These are the accepted parameters, but these can be adjusted to meet the needs of the user.
Fast Stochastics: %K and %D
%K = 100 X (C – Ln) / (Hn – Ln)
C = The latest (or closing) price
H = The highest price over the last n periods
L = The lowest price over the last n periods
H3 = the 3-day sum of (C – Ln)
L3 = the 3-day sum of (Hn -Ln)
Slow Stochastics
Extend this relationship a step further to help smooth it replaces the %K line with the %D line and replaces the %D line with a 3-day moving average of %D
Because Fast Stochastics can be quite volatile, traders will often use Slow Stochastics, which are an extension of the relationship and are designed to reduce volatility. Slow Stochastics also consist of two lines, using %D (as the mainline) and a moving average of %D (as the signal line).
How to read Stochastics
Stochastics are plotted within a range of zero and 100, with 50 as the neutral level. Trigger levels are added to the chart at 20 and 80.
- When the Stochastics lines are above 80, the price is considered to be strongly bullish or overbought.
- When the Stochastics lines are below 20, the price is considered to be strongly negative or oversold.
The table below shows the basic interpretation of Stochastics:
| Stochastics level | Outlook |
|---|---|
| 0 - 20 | Very BEARISH, but over-extended |
| 30 - 50 and rising | Unwinding a bearish configuration |
| 50 -70 and rising | Increasingly bullish |
| 80 - 100 | Very BULLISH, but over-extended |
| 50 - 70 and falling | Unwinding a bullish configuration |
| 30 - 50 and falling | Increasingly bearish |
Trading crossovers
When fast and slow stochastics lines crossover, it is often a trading signal. When the fast stochastic (Main Line) crosses through the slow stochastic (Signal Line) in one of the two extended zones (either above 80 or below 20), you should be on the alert for potential reversals and trading signals.
Some traders will act when a crossover appears. However, Stochastics can be over-extended for some time before a reversal is seen (see Figure 1). That makes it prudent to wait for the Main Line to move either back above 20 for a crossover buy signal, or back below 80 for a crossover sell signal.
This can help to increase the conviction of the signal.
Divergences
As with other momentum indicators, divergences are often an early warning signal of a change in the direction of a trend.
In an uptrend, bearish divergences where the price continues to make higher highs, while the Stochastic lines are either in decline or making lower highs, can be a signal of a slowing uptrend and potentially, a reversal lower.
In a downtrend, a bullish divergence (price making lower lows, while the Stochastics lines are advancing or beginning to make higher lows) can be an early sign of a slowing downtrend and potential reversal higher.
Figure 1: A series of trading signals using the Stochastics on USD/JPY
In the USD/JPY example above, between November 2016 and July 2017 stochastics delivered several signals. As an indicator, stochastics will tend to work better in a sideways trending market, but it is interesting to see that with a mild negative trend drifting lower, the sell signals work much better than the buy signals here.
Between December 2016 and July 2017 the sell signals are clearly evident. Where the bearish cross-sell signals are confirmed (crossing back under 80), there were four key signals. The bearish divergence also worked provided a signal where the Stochastics crossed back under 80.
It’s interesting to note that between January and March 2017, the buy signals were weak (very choppy) and didn’t work as signals. After then the signals became stronger in April and June, demonstrating more conviction, there were two strong buy signals.