Stochastic is one of the most commonly used oscillators by traders. It was developed by George C. Lane in 1950. Lane was a futures trader who sought to gauge the relationship between the closing price and the price range of the asset. Stochastic is now used in technical analysis not just for the futures market, but for all markets.
Stochastic calculates the closing price’s position relative to the lowest low of the period as a percentage of the price range. This calculation is represented as ‘%K’:
%K = ((Current Close – Lowest Low)/(Highest High – Lowest Low)) * 100
The main indicator is ‘%K’, and because it is a percentage and shows relative position, it ranges between 0 to 100. Just like RSI, the main purpose of stochastic is to determine the relative position – whether it is ‘oversold’ or ‘overbought’.
Overbought – Oversold
Using stochastic indicators to capture tops and bottoms can yield significantly different results depending on the market conditions. In the example provided, we analyzed a daily gold chart. During periods when the price movement is flat, signals indicating ‘overbought’ and ‘oversold’ conditions tend to perform well. However, when the price is consolidating, such as in a wedge or triangle formation, reversals may not offer substantial profit opportunities as both gains and losses are typically limited.
Following a period of consolidation, a breakout often occurs, leading to a strong trend. During such trends, stochastic indicators may remain in the ‘overbought’ or ‘oversold’ zone for extended periods, resulting in multiple false signals. Therefore, this aspect of stochastic analysis may not be effective during trending market conditions.
%D Line Cross
%D is the moving average of %K and is used for generating ‘buy’ and ‘sell’ signals. However, as seen in the chart below, it often produces too many false signals to provide meaningful trading opportunities.
To overcome this obstacle, a smoothing method can be applied. The chart below depicts the same period, but instead of using the normal stochastic, a double smoothing technique is employed. The smoothing method causes slightly delayed signals, so during very tight movement periods, it may result in numerous small losses. However, during higher volatility periods with multiple trends, it can generate many meaningful ‘buy’ and ‘sell’ signals. In the graph below, green and red arrows indicate ‘buy’ and ‘sell’ signals, respectively, and profits are represented by solid lines, while losses are denoted by dashed lines.
Divergence
Like most oscillators, stochastic can also be used to identify divergences. In the example below, while the price is making new lower lows and lower highs, stochastic forms two higher highs and higher lows. Combined with the breakout from the trendline, similar setups might create opportunities for traders. The key point in using divergences is that they are sometimes realized too late, so it is important to use them in conjunction with additional information, such as breakouts from trendlines or horizontal resistances.
