Thinking ahead with Stochastic:
The stochastic oscillator is a momentum technical indicator, which uses the basic support and resistance levels and integrates them with the trend to give an accurate buy or sell signal.
Using stochastic, a trader can gauge the momentum and interpret over brought and oversold condition of a security, currency or an index. Momentum oscillators such as stochastic can give clues when the momentum is slowing down or picking up.
“Instead of using all indicators that are almost derived from closing prices, use of a novel tool like stochastic can add more value to decision-making, as it captures the momentum on the basis of an entire price range over a period,”
Stochastic is measured with the %K line and the %D line. Traders should follow the %D line closely because that indicates major signals on the chart.
A default period of 14 is used to calculate the stochastic oscillator, which is commonly referred to as %K. The K line is the fastest while the D line is the slower of the two.
In other words, a slow stochastic is nothing but a three-period average of a fast stochastic. “A close observation will reveal that the %D line of the fast stochastic is equal to the %K line of the slow stochastic,”
For decision-making, investors need to watch the D-line. If the price of the security moves above the 80 level, it signifies over brought condition. If the value moves towards 20, it will signify an oversold zone.
“The stochastic value, which is referred to as %K, is smoothed by applying three-day moving average to generate BUY/ SELLsignals and this value is called as % D,”
Traders can buy a stock when this indicator shows oversold condition and sell it when the when the indicator moves beyond 80.
Apart from generating buy and sell signals based on the trigger line (%D), a stochastic oscillator is also useful in identifying oversold and over brought conditions and bullish or bearish divergences.
How top investors & traders decisions on Stochastic indicator:
“In a stochastic, the fast indicator is highly sensitive as it is formed by taking a daily price readings. It can fool traders into thinking that trade is possible when it may not be so,”
“The slow stochastic indicator, on the other hand, takes the average of such sensitive readings and smoothness the fluctuations for a more visible trade able signal. Most charting software now can be optimized to the trader’s preference and can thus suit each trader’s need,”
“When the faster stochastic crosses over against the slower one, it indicates a change in the short-term momentum and can be interpreted as a signal to enter the security,”
When not to use stochastic:
Stochastic have been around for over 50 years and just like most indicators, they cannot be looked at in a vacuum. “This should be taken into consideration alongside a tested trading strategy and could act as a supplement to the inherent trading decision,”
Trading with stochastic is not that simple, but in tandem with other indicators and experience, good traders can make a lot of high-probability trades using stochastic
“In small cap or midcap stocks, where liquidity is often scarce, or during wild trends like daily upper or lower circuits, this indicator should not be used as the stock or commodity can remain in over brought or oversold zones for prolonged duration, giving false signals for a counter-trend,”.