Before we continue a further discussion about how to use this stochastic indicator we need to know the history of this indicator as an additional insight for this indicator
Stochastic indicator is one type of oscillator indicator made by George Lane and was introduced in the late 1950s.
Stochastic oscillator is the first indicator used by analysts to predict the direction of price movements. George Lane made this indicator on the basis of the reason that the compilation market is going up, prices will increase above or equal to prices in the previous period;
While when the market is downtrend, the price will move below or equal to the closing price in the previous period.
By using a scale to measure the magnitude of changes between prices in one period to the next, the Stochastic indicator provides an upward trend in the direction of ongoing trends.
By giving on that scale, traders can look trading signals given the Stochastic indicator.
Stochastic Indicator Component
The stochastic indicator consists of two components that are displayed simultaneously, namely:
% K line which measures the current level of price changes.
% D line is the Moving Average of the line% K, or% K which is refined. This line is also called the signal line.
Calculations of formulas for% K and% D for a certain period are:
% K (N) = 100 x (CP - LP) / (HP - LP)
CP is the closing price in period N, LP is the lowest price in period N, and HP is the highest price in the period N. George Lane recommends period 14 (N = 14) for standard use assuming that the required measurement sample is sufficient. Traders also use periods 9 and 21 as alternatives.
% D (N) = Simple Moving Average (% K, N)
Because% D is the average value of% K at a certain period (N), then% D is also called "Slow Stochastic" because it reacts slower (red line in the image below), while% K is called "Fast Stochastic" ( blue line in the picture). The combination of% K and% D is called Full Stochastic.
How to Read Stochastic Oscillator in Forex Trading
Generally, this indicator is used to detect oversold and overbought areas. Through the upper and lower levels, the signal from the stochastic oscillator indicator is used to signal to buy if the line at the lower levels, and sell if the line at the top levels.
But, Stochastic indicators in forex trading can be used based on three references, namely crossover, divergence, and overbought and oversold levels.
The ideal level value for the lower limit and upper limit is 20 and 80. For the middle level, it is used as a measure of 50 to read the weight of the price movement after being below level 50 or above the level of 50.
Stochastic Crossover as a Trading Entry Indicator
The most important component in how to read the Stochastic indicator as a sign of entry trading is the crossing of signal lines. In contrast to RSI which has only one signal line, Stochastic has two dynamic lines which are named% K and% D respectively.
If you use the MetaTrader 4 platform, the default display% K Stochastic is a green line, while the% D line appears as a red dashed graph. Apart from appearance, the two lines also have different calculations.
Line% K Stochastic
Measuring the rate of change in current prices (fast stochastic),% K is generated from the following calculation:
For example, the period% K is 5, then the formula is: 100 x (the closing price of 5 days - lowest price of 5 days) / (highest price of 5 days - lowest price of 5 days).
Line% D Stochastic
Also called slow stochastic, the% D line actually shows the moving average of% K. The way to calculate it is to provide a Simple Moving Average calculation at the value of% K.
Then how do you read the stochastic indicator to find the entry trading signal? The answer is easy. Not much different from the trading strategy with the MA line crossing, you can also pay attention to the crossing between% K and% D. Because% K acts as fast stochastic and% D is slow stochastic, the buy signal appears when% K crossing up % D from the bottom. Conversely, a sell signal occurs when% K crossing % D from top
If this cross occurs in the overbought oversold area, then this is a more confirmed entry trading signal. In essence, how to read the Stochastic indicator as a sign of entry trading is to recognize the crosses of the% K and% D lines in the overbought oversold zone.
Stochastic is a marker of divergence
Divergence here means the gap that occurs between the lines% K and% D. Because% K moves faster than% D, the gap that occurs indicates the strength of the trend direction movement. The wider the gap, the stronger the trend. Conversely, if both lines approach each other (more narrowing), it means that the weak trend is happening, as well as a signal for possible changes in the direction of the trend.
Like other oscillators that can function as momentum indicators, Stochastic is one of the main indicators in divergence analysis.
If MACD divergence uses a measurement of up and down bars, then how to read the Stochastic indicator as a divergence indicator relies on the peak (high) and the base (low) formed from the signal lines.
If the Stochastic chart shows a high or low which is declining, it indicates a weakening of momentum.
Conversely, how to read the Stochastic indicator when momentum is strengthening is to pay attention to the increase in the high or low of the signal line.
In the example image above, the strengthening of prices is marked by increasing highs. But actually, the momentum is actually weakening, because the Stochastic high seems to be declining.
This shows that bullish prices are not supported by actual momentum. Thus, it can be concluded if the price uptrend will reverse following a decline in momentum.
Stochastic As a Marker of Overbought Oversold
How to read the Stochastic indicator according to this function is the easiest. Basically, the indicator of George Lane's creation has two extreme levels, 80 and 20. Each of these levels acts as an overbought and oversold limit. The Stochastic indicator shows an overbought condition when the chart is above level 80. Meanwhile, how to read the Stochastic indicator to recognize oversold is to pay attention to the chart that has dropped below the level of 20.
However, it should be noted that it is not recommended to immediately enter trading after successfully practicing how to read the Stochastic indicator above.
Often, these signals cannot be relied upon when the price trend is strong.
3 Important Tips This uses stochastic
To minimize false signals when applying how to read the Stochastic indicator, do not do technical analysis in just one-time frame. For example, if the price is making an uptrend move in the H4 time frame, observe the oversold moment in the H1 time frame also before making an open buy.
In addition to understanding how to read the Stochastic indicator, you should also use indicators or other methods of technical analysis as support. You can use price action, chart pattern, or other indicators such as the Moving Average.
You can add level 50 to the Stochastic indicator. How to right-click the indicator then select "Stoch properties". On the "Levels" tab, click "Add" then enter the number 50 and press OK.
How to read the Stochastic indicator with an additional level 50 is:
Stochastic has dropped from overbought levels, crossing% K and% D has also indicated sell. Although there are already 2 bearish signals, traders may not open a sell position before the price actually drops to break the level 50. Here is an example of the graph:
How to read this Stochastic indicator can filter false signals, but requires more time to ensure confirmation of the trading entry. If you are a conservative trader, then how to read the Stochastic indicator with level 50 can be relied upon to minimize risk. But if your forex trading style tends to be aggressive, confirmation of the open signal from overbought oversold and crossing the line is enough.
More than just a sign of overbought oversold, Stochastic can be a multipurpose indicator.
With the crossing of the signal lines in the overbought oversold zone, you can get more confirmed trading entry instructions.
Besides, Stochastic is to show divergence which can be used as a leading reversal signal. All of that can be learned and applied easily if you master how to read the Stochastic indicator according to each function.