How to use Stochastic Indicator like a Pro – [One Stop Guide]

The Stochastic Oscillator is a momentum indicator. The oscillator follows the speed or momentum of price and not price or volume.

The oscillator ranges from zero to one hundred, usually Stochastic settings use 80 as the overbought threshold and 20 as the oversold threshold.

Transaction signals are created when the %K crosses through a three-period moving average, which is called the %D.

Stochastic Oscillator is a range bound indicator and hence it is useful for identifying overbought and oversold levels, It also helps in identifying bullish and bearish divergence.  

The default setting for the Stochastic Oscillator is 14 periods, which can be days, weeks, months or any intraday time frame. 

Stochastic Indicator is one among the famous indicators that most of the traders use. Developed by George C. Lane in the 1950s,.

If the stock is in overbought region it does not imply that the stock will fall immediately ,Stocks can be in overbought region for a long period of time during a strong uptrend.

In the similar way if the stock is in the oversold region does not imply that the stock will rise immediately, Stocks can be in the oversold region for a long period of time during a strong downtrend.

Biggest mistake beginners make while using stochastic oscillator indicator:

The biggest mistake made using stochastic indicator is buying/selling at all the crossovers, This will lead to loss.

Always understand how the indicator works and then take trade accordingly.

(With power comes responsibility, so use this powerful indicator for making profits and not loss !)

PRO TIP: The solution for this is to identify the bigger trend and trade in the direction of this trend.

Watch this video for easy understanding

Chart setting for stochastic trading:

  1. Add stochastic 14 or 8 period to your chart (This depends on the type of trader, 8 period gives more signal compared to 14 periods)
  2. Add 200 Exponential moving average (EMA) to identify the direction of the trend. If the price is above 200 EMA you buy and if the price is below 200 EMA you sell.
  3. Add 20 EMA for filtering the signals given by stochastic indicator.
  4. Use stochastic overbought and oversold condition to generate buy and sell signals.
  5. The crossover point of %k (Fast) with %D (slow) is used for generating a signal.

Pro tip: Add 20 EMA, which acts an additional filter, We buy when price is above 200 EMA and 20 EMA

Different Strategies explained using Stochastic Oscillator Indicator

1. Buy Condition using stochastic oscillator indicator: Explained with taking Tech Mahindra as an example

  1. We analyze for the price: If Price is above the 200 EMA, we look only for buying opportunity – 200 EMA must be sloping upwards.
  2. We wait for the fast line to crossover the slow line from oversold region and move above 20 >> This is a buy signal
  3. We buy and wait till the stochastic fast line crosses the slow line at the overbought region, Wait till it crosses below 80 from above to confirm the change in direction of momentum (You can also wait till the price moves below 20 EMA)

If you are aggressive trader ( i.e Risk taking capacity is more ): One can buy at all the crossovers given by stochastic in the buy side ( see the video for more detailed explanation)

Pro Tip : Use Heiken Ashi candles for easy analyzing of trend.

2. Sell condition using stochastic oscillator indicator: Explained taking Jet Airways as Example

Here, We do opposite of what you learnt for the uptrend.

  1. We analyze for the price: If Price is below the 200 EMA, we look only for selling opportunity.
  2. We wait for the fast line to crossover the slow line from overbought region and move below 80 >> This is a sell signal
  3. We sell and wait till the stochastic fast line crosses the slow line at the overbought region, Wait till it crosses below 20 from below to confirm the change in direction of momentum. (You can also wait till the price moves above 20 EMA)
  4. If you are aggressive trader ( i.e Risk taking capacity is more ): One can buy at all the crossovers given by stochastic in the buy side ( see video for more detailed explanation)
Pro Tip : Use Heiken Ashi candles for easy analyzing of trend.
Sell-using-Stochastic-Indicator-analyzing-the-trend

3. How to trade Trendless (range bound) markets using stochastic oscillator indicator?

n the range bound market, there is no definite trend, these ranges are generally accumulation or distribution phase.

Range markets can be identified by drawing a moving average,I have used 20 EMA here, and the prices will be oscillating above and below the moving average.

Stochastic oscillator can be used to trade range bound markets.

Once the range bound market is identified, the crossovers of stochastic fast and slow lines for both overbought and oversold region are traded.

In the figure above both the extreme crossovers are traded, if the width of the range is more it will lead to more profitable trade.

Trading-Range-bound-market-using-stochastic-indicator

4. Trading Divergence using Stochastic oscillator Indicator:

Disagreement between the indicator and price is called divergence, Divergence can be used for profitable trading and also can help in trade management.

  • In an uptrend, Divergence occurs when price makes a higher high but the indicator does not.
  • In a downtrend, divergence occurs when price makes a lower low, but the indicator does not.

When divergence is spotted, there is a higher probability of a price retracement.

Divergence explained: Taking Tech Mahindra as an Example

Identification-of-Divergence-using-Stochastic-Indicator

In the chart, Price is making Higher high but the indicator is forming lower low which is an example of divergence.

When there is Divergence, the price usually follows the indicator direction, Traders should always keep an eye for Divergences.

Conclusion:

I am sure you now have in depth understanding of how stochastic work and how to use stochastic indicator to trade Trending, Trend less markets and also identify and trade divergences profitably.

Try this strategy and let me know how was your experience trading using this strategy.

How to select stocks for Intraday? Read here – Open-high-low-scanner

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