What is a Stochastic Indicator?

What is Stochastic Indicator?

Stochastic is something that is related to probability distribution, for example, a random variable. A Stochastic Indicator is a measure of the relationship between price range of a crypto asset over a fixed period of time and asset’s closing price. It is a type of oscillator that the momentum traders have been using to know buying and selling signals.

Introduction

This indicator was first popularized by George Lane. According to dictionary.com, the word stochastic refers to “of or relating to a process involving a randomly determined sequence of observations each of which is considered as a sample of one element from a probability distribution.” The indicator is based on the assumption that during the uptrend, the closing price of crypto is more likely to be in the upper end of the price range.

The indicator is based on the assumption that during the uptrend, the closing price of crypto is more likely to be in the upper end of the price range. During the downtrend, the process tends to be more near to the lower end of the price range. This way, it is a measure of the relationship between price range of a crypto asset over a fixed period of time and asset’s closing price.

A Stochastic Indicator may seem complex by its definition but it is actually very simple to use and is more accurate than other trading indicators as it gives more accurate buying and selling signals. It is a momentum oscillator and according to George Lane, “Oscillator does not follow price, it does not follow volume or anything like that. It follows the speed or the momentum of price. As a rule, momentum changes direction before price.” It is for this reason that this indicator gives more accurate signals than other indicators.

Indicator Explained

In the following paragraphs, we have stochastic oscillator explained for you:

The %K and %D Lines

The %K and % D lines are the hallmark of a Stochastic Indicator. These two lines are used for measuring the stochastics. The purpose of these two lines is to calculate where does the most recent closing price of the crypto asset lies in relation to a pre-determined price range of that asset over a fixed time period,. The time period chosen for an SI is mostly 14. This could be 14 days, weeks, or months. For short trading periods, intraday charts are used while for longer periods, we use weekly or monthly charts.

The %K Line: It is faster than the D line and is the more sensitive one. To determine the K line, we use this formula:

%K = 100 [ (C-L14)/(H14-L14) ]

where:

C is the latest Closing Price of the crypto asset.
L14 is the lowest low of the asset over a time period of 14 (days/weeks/months)
H14 is the highest high of the asset over a time period of 14 (days/weeks/months)

The %K determines, in range between 0 and 100, how far or close the latest closing price is to the price range of the asset over the selected time period. For example, if %K value comes out to be closer to 80, this indicates that closing price is more close to the upper price range and a value closer to 20 indicates that the price is more close to the bottom price range. As simple as that!!

Note: We follow D line more closely as it gives stronger signals as compared to the K line.

The %D Line: The %D line measures the 3-period moving average of the %K line. It is measured with this formula:

%D = 100 [H3/L3]

where:

H3 is the highest price traded during the three-day period
L3 is the lowest price traded during the three-day period.

As we measure %D over a time frame of 3, it is considered a slow line. It is slower than %K.

Intent of Stochastic Indicator

The goal of this indicator is to find when the price of the asset has moved into the oversold or overbought regions. When the stochastics tend to move above the 80 line, the asset is said to be in overbought position, while when it moves below 20, it is said to be in the oversold region.

The movement of the indicator above 80 is an indicator for selling the asset while its moving below 20 is a buy signal (though these are not accurate all the times!). An asset might continue to be in overbought or oversold regions for extended periods of time. So, a trader should use it in conjunction with other indicators to get the accurate buy and sell signals.

Stochastic Indicator: Overbought Condition — Stochastic above 80 shows overbought condition and predicts a price drop

An Example

As we said earlier that it measures how far or close of the closing price relative to the price range over a time period. In the above formula for %K, if we consider that H14 = 280, L14 =200, and the last price at which the asset closed = 270. Therefore, as per above formula, ‘

% K = 100 [(270-200)/(280-200)]

which comes out to be 87.5%, which is closer to the upper price range and so, the asset is in overbought region.

Stochastic Indicator Strategy

Bullish and Bearish Divergences

A trader should watch for the divergence that takes place between the asset price and the % D line. A Bullish Divergence is observed when the %D line goes below 20 and forms two rising bottoms while the price of the asset moves lower. Conversely, a Bearish Divergence is observed when the %D line goes above 80 and forms two lower lows while the price moves higher.

Crossover Signals

A buy signal is indicated when the %K line crosses and moves above the %D line. This indicates that the price can go higher. Conversely, if the %K line crosses the %D line and moves below it, it is a sell signal. Some traders also use the 50 level crossover method: When the %K line crosses above the 50 level, it is a buy signal while when %K crosses under the 50 level, it is a sell signal.

Disclaimer

This article is for informational purposes only and is NOT a financial advice. We do not promote, in any form, any trading strategies, cryptocurrencies or tokens mentioned herein. The content of this article is based on the information available up to the knowledge. You should be aware that investing in any trading strategies, cryptocurrency, or web3 project is subject to market risk and you MUST do your own due diligence (DYOR) before you put any money in any of the strategies or coins.

Anuradha

A blockchain writer and a cryptocurrency enthusiast. First-hand experience of working in web3 domain in which I create blockchain content for both developers and end-users. A blogger by choice and passion. My interest in blockchain is only growing up with the passage of time.