The stochastic indicator was designed by George C. Lane in 1954 at a time when trading in the pits was the order of the day in the American futures markets and these indicators, when they were released, were sought by many traders in that market.
To get an idea of what the environment was like in those days, George Lane worked side by side with Joseph Granville, one of the legends of the stock market analysis.
Golden age of the markets, no doubt.
This indicator is of the oscillating type and is a variable that is constructed to give results that go between two bands that are those of 0 and 100 to be able to determine, as always with these indicators, if the graphs are oversold and overbought, or if they are in trend or not.
In the initial studies of these oscillators built up to 28 different oscillators but many of them did not serve as impractical, especially at a time when graphics were manual in many cases.
The stochastic as an indicator must move between the closed interval of 0 and 1, which in this case would represent 0 and 100%.
How is the stochastic indicator calculated?
This is an indicator that includes two oscillators called fast (% K) and slow (% D).
To calculate the stochastic we would have to calculate these two oscillators, being:
% K = 100 x ((C-Min) / (Max-Min))
% D = Simple moving average of 3 periods of the oscillator% K
Note that the “3” period is applied because it is considered the most appropriate, but we could apply the 4 or another number, which we should then review in the graphs to see if we believe that with it we have better crosses and, for fherefore trading opportunities.
C = current closing
Min = the lowest value of the period
Max = the highest value of the period
The period that we will find by default for this indicator is 14 days, which is what we will find in most platforms, be it Metatrader 4, Ninjatrader, Prorealtime, Tradingview or others.
Therefore, with this indicator we would have two lines that would be% K and% D.
The% K would be the line that would give us the signals when crossing with% D, which would be the main oscillator.
As simple as that.
Now we are ready to apply it and make money in the financial markets?
Do not go so fast my friend, because as happens with all indicators the application of this is much more complex than it seems at first glance; I mean the application to make money consistently, obviously.
How to interpret the stochastic?
Well, as I said before that we were not so fast here I am going to comment on the fact that the author did not consider that the crossings of% D and% K were good trading signals, but possible warnings.
According to Lane’s study, the signals to be considered would be those that create divergences between the price and the% D oscillator.
How to know when these divergences occur?
For when the oscillator is forming ascending minimums and the price forms minimum in a descending manner we would be facing a potential bullish signal.
On the contrary, if the price gives us rising highs and the oscillator gives us falling highs we would have to consider a bearish operation.
However, note that with the latter and a subject of quite large subjectivity is added because in this case we no longer have two lines that cross and give us a clear signal of operation, but we have to interpret two variables that are in different graphics and in which we will also have to analyze the movement dynamically, almost to “eye”. This way is more complicated, but honestly, I like it, more, like everything that is done to “eye”, that is, in a more qualitative and less quantitative way; although it is the latter that is more “fashionable” today.
Now, I tell you that to apply this method of divergences you will have many difficulties, and if you do not look at the graphics to see what you “see”.
Other interpretations of stochastic
One way to interpret the stochastic indicator is through the “overbought” and “oversold” levels.
When does the Stochastic “tell us” that the market is oversold or overbought?
Well, obviously, when the value of it is close to 100%, is that it is overbought and if it is close to 0% is that it is oversold; although just remember that does not mean that the price does not continue rising or falling respectively, but we are talking about the “theory”.
For example, areas close to 70 or 80% indicate possible “overbought”, while areas close to 20 and 30% indicate possible “oversold”.
Applying the oscillator with oversold and overbought
A case in which we can see a possible application, even if it is very approximate, since to do it well we would have to refine a lot of data, it is the attempt to make overbought and oversold operations when the price is at levels over 80 or less than 20.
Let’s see what happens when the price crosses the oversold side to give us possible upside operations.
- We can buy when the oscillator we choose (K or D) crosses down the level of 20.
- We can also buy when you reach the level of, for example 10
- We can also buy when the level of one of these oscillators cross again the line of 20 to go up
As we can see, only in this case are the possibilities infinite, because when changing the variables we can have endless options.
For example, we can see it in a chart with weekly candles like the one at the beginning of the article, where “it works” sometimes but sometimes not.
As always, it will work better in some assets than in others, and depending on conditions.
The problem always comes with the issue of how long a bullish or bearish market can be, because if a bull market lasts a lot we will have many false oversold signals and vice versa.
Therefore, one will have to spin much finer than the simple logic of “buy like this” or “sell like that”.
What temporality to use with the stochastic?
Well, here comes a very important issue because in theory this indicator, like any other should serve both for one season and another, but I tell you that that is not so.
It is not the same to operate a stochastic in a graph with monthly bars with some primary tendencies than to try to operate a stochastic in a 5-minute chart where we will have long periods of time in which the market will be “resting”, distorting the “general equation” ”
This is where the danger comes in when a lot of people want to use this indicator to do day trading
Use the stochastic oscillator for day trading?
That is the dream of many traders who throw themselves into the study of these technical indicators.
With the stochastic it is not different.
The problem is that, as always, this indicator will give us many false signals and many true, almost in a way that we could consider random.
I already tell you that in order to be successful with it you will have to know very well the asset in which you are negotiating and try to find the most likely market side, for which you will have to use other more advanced techniques; because trying to apply the indicator blindly, in the end will result in too many false signals; trust me.
One way to reduce the number of signals and achieve them with a higher “quality” is to increase the period over which we apply the calculation.
There are people who use periods of 20, 30. 40, etcetera.
I, according to the case, and if we are in pretty small bars, I use up to 100, 150, 200 or more. With this we will have fewer operations but in those cases we are looking to take the “good ones”.
You can see the difference between using a period of 14 and another of 200, for example.
Where before you had 6 signals, now you only have 1.
Stochastic in side markets and in trend markets
If we use stochastic logic, when we have markets in trend, for example bullish, we will try to use only those signals when the market is oversold.
If we have side markets then it is possible that we can use both the purchase and the sale.
How to know if we are in a side market, bullish or bearish?
That’s the crux of the matter.
What we can most know is how the market was in the past.
Knowing this we already have something, even a small thing.
That something tells us that stock markets tend to rise and therefore if we are going to use this oscillator it would be better if we did it for the long side of the market than for the short side.
In an action like Amazon, for example, we will always have better conditions if we operate higher.
However, if you look, the market is so exaggeratedly bullish that it gives us few opportunities to enter long if we take as a reference the 20 of stochastic.
Look, on the contrary, it gives us more false signs of overbought.
In this case it would be better to even raise the oversold to the level of 25, for example.
The possibilities we have are endless and only with this indicator could we spend endless study evenings.
I encourage you to do it, because with certainty it is an indicator that can give us good possibilities.
If, in addition, we are able to apply good techniques of money management and trading, even better.
Greetings and good trading.
Original article: Cómo usar el oscilador estocástico