Trading with the Stochastic Oscillator
The stochastic oscillator, along with the RSI, is one of the main momentum indicators used by traders to analyze the market. It is also one of the oldest, having been introduced by George Lane in the 1950s.
The stochastic graphically appears as two lines plotted below the main price graph, named %K - the so-called “signal line” - and %D, the oscillator itself.
They are calculated as follows:
%K = (close - min (low (%K))) / (max (high (%K)) - min (low (%K))) * 100
Close: is the current closing price
Min (low (%K)) is the lowest low of the %K periods
Max (high (%K)) is the highest high of the %K periods.
%D = SMA (%K, N),
N is the averaging period
SMA is a Simple Moving Average
Zooming in on the stochastic oscillator. Notice how the lines intersect and how the indicator moves between overbought and oversold areas.
In other words, the stochastic oscillator compares the closing price of a crypto asset with its range over a period of time and is represented by two lines frequently intersecting each other and oscillating between 0 and 100.
Trading idea: use the stochastic to find oversold and overbought levels
Much like its momentum cousin, the Relative Strength Index (RSI), the stochastic oscillator can be used to find out when an asset is being oversold or overbought and a correction is expected. More specifically, when the price is above 80, a downward correction may be on the cards and when the oscillator descends below 20, an increase in price may occur.
A short uptrend breaks out after the oscillator moves below the 20 line
A bearish downtrend forming as the oscillator moves down from overbought territory
It is worth remembering, however, that like other momentum indicators, the stochastic can remain in overbought or oversold territory for relatively long periods of time if the price is trending, making this strategy more suitable for sideways markets.
Trading idea: stochastic crossovers
Traders see crossovers between %K and %D as signals, assuming these take place in oversold or overbought territory.
When the %K crosses %D from below, this is considered a bullish signal if the oscillator is moving below 20. Viceversa, if %K crossed %D from above and the oscillator is above 80, a bearish signal s formed, telling traders to sell.
Both bearish and bullish crossovers on the stochastic chart
Trading idea: divergences
The stochastic oscillator is also popular for trading divergences - instances when the indicator and the price are out of sync, and a trend reversal is probable since momentum is already changing but this does not yet show in price action.
More specifically, if the price makes lower lows but the indicator does not, a bullish signal is forming, indicating that the price may soon reverse upwards.
If instead the price makes higher highs but the oscillator does not, this means that traders will expect the price to begin descending.