When it comes to crypto trading, the stochastic indicator is one of the most used and favored technical indicators. As it is bound by a 0 to 100 range of values, it’s a type of momentum indicator. As with any indicator, the stochastic indicator – or stochastic oscillator as it also referred to – definitely has its strengths and weaknesses, and it’s advised to use it combined with another indicator.
A closer look at the stochastic indicator
The stochastic indicator was developed by George Lane in the 1950s. He designed the indicator to calculate the location of the closing price of an asset compared to the low and high range of the same asset over a period of time.
There are different settings for the stochastic indicator, but usually the default setting is (14, 3, 3). This means the indicator looks at a timeframe of 14 periods (intraday, days, weeks, months), using the most recent close, highest high and lowest low. It then uses a 3-day simple moving average to plot a line over the 14 periods which acts as a signal or trigger line.
%K = (Current Close – Lowest Low)/(Highest High – Lowest Low) * 100
%D = 3-day simple moving average of %K
Lowest Low = lowest low for the look-back period
Highest High = highest high for the look-back period
%K is multiplied by 100 to move the decimal point two places
Reading stochastic signals
The stochastic indicator is used to assess the current market sentiment. It is designed to always provide readings between 0 and 100, with readings closer to 0 indicating a bearish state and 100 a bullish state. Unlike other crypto trading indicators, stochastic doesn’t display negative readings or any number above 100.
Typically, 20 and 80 are used by crypto traders as important threshold values. Any readings below 20 indicate the mark is in an oversold condition, whereas a reading above 80 signals we are trading in overbought conditions. Bear in mind that when the indicator hits readings way above or below 80 and 20, it still simply signals overbought or oversold conditions. It does not automatically mean a reversal is at play.
Avoiding common mistakes made by crypto traders
Taking especially high or low readings as a reversal signal is a typical mistake made by crypto traders when they first start using the stochastic indicator. As indicated in the Bitcoin price chart below, the reading is higher than 80 which means BTC has entered overbought territory. If you take is as a reversal pattern, this would be when you short Bitcoin. But, the 82 reading can always become 88. The same counts for extreme low readings in the BTC charts.
Stochastic, high reading indicating overbought market (Source: TradingView)
Another thing about particularly high or low readings, is that the stochastic travels slower in extreme readings. The indicator will move from 48 to 58 much faster than it would from 84 to 94. Back to the BTC chart above, the price moved from $10,250 to $10,450, even though the stochastic had been reading overbought condition the entire time.
That’s why crypto traders should always combine the stochastic indicator with other indictors and patterns.
How to generate trading signals with the stochastic indicator
There are two popular trading techniques to generate trading signals by using the Stochastic oscillator.
1. Looking for divergence
Divergence happens when there is a difference in signals between the stochastic oscillator and the current trending price action. Looking at the price chart below, we see that the price action creates a lower low. However, when we use the stochastic indicator, it prints a higher low at exactly the same time.
This type of divergence is called a bullish divergence as it indicates a signal to take a long position. And it works the opposite way as well. If the price action makes a higher high, but the stochastic indicates a lower high, consider taking a short position.
Stochastic divergence sample (Source: TradingView)
2. Combining signals
The second crypto trading technique is to combine signals from the stochastic indicator and other technical indicators. The way this works is illustrated in the BTC price chart below.
Using the moving average and Fibonacci retracement, we can identify a signal to short BTC/USD as the price touches the key resistance levels – the 200 MA and 61.8% Fibonacci retracement zone on a daily chart.
Moving average & Fibonacci combined with Stochastic (Source: TradingView)
To verify the signal’s reliability, we can apply the stochastic indicator which in this instance reads above 90. This indicates Bitcoin is overbought on a daily basis. And with all three technical indicators suggesting a reversal is in the cards, a short position is finally initiated.
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