Part 17 Technical Analysis – Stochastic oscillator

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Part 17: Technical Analysis – Stochastic oscillator

In our today’s article, we will be talking about an indicator used by and popular especially among the beginners. The popularity stems from being part of many strategies available at various websites, forums etc. Therefore it is easy for a beginner to get used to using it and follow it in spite of not knowing what its values actually mean.

Would you like to know what indicator I am talking about? What values does it show? What do these values mean and how to use the indicator? Continue reading to learn more!

Stochastic oscillator

This oscillator has been with us for a few decades. It was first described by George Lane in the 1950s. Stochastic indicator does not show the price of a given asset or the volume of trades made. It shows the speed of price changes. These changes are translated into figures on a scale from 0 to 100, and can be easily plotted in a chart.

This is what stochastic oscillator looks like

As mentioned above, the picture clearly shows that the values of the oscillator move i.e. “oscillate” between the values of 0 and 100. This is quite simple. But what do these values represent?

It’s simply as follows:

  • When the line (the value of stochastic oscillator) is at the top (nearing 100, let’s say, 80+) this means that the asset is overbought.
  • When the line is close to the bottom (below 20, let’s say), we may assume that the asset is oversold.

Overbought and oversold

The two terms can be translated simply as follows: overbought means that the asset is being excessively bought, oversold meanst he opposite: an excessively sold asset. This is exactly what the stochastic indicator shows. It shows the current demand for an asset. These indications may mean two things:

We can either expect a trend reversal (…turning the overbought into oversold) or the opposite move – status quo for some period of time. As clearly shown in the picture below, both options may happen.

Ignore the arrows down at the bottom of the stochastic oscillator

As you can see from the above picture, both cases do happen.

  • As soon as the oscillator falls below the 20 line (at the start of the Fibonacci lines) the price went up. An oversold asset has turned into an overbought, leading to an instant rise.
  • After the first rise above 80, the values remained unchanged for pretty long and the buyers continued buying. Instead of going down, the price went even higher.

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How to use stochastic indicator?

This indicator can be used in two ways. You can use it as a tool for trade filtering. You can either trade with the trend (prices changes following the long-term trend) or in the opposite direction.

Case 1:

Case 1: Twin peak, 100% rebound Fibonacci confirmed by the reversal of Stochastic indicator

This case shows how you can use the stochastic indicator to confirm signals. On the chart’s left side, you can see two arrows produced by the BERSI Scalp strategy. If you had used the stochastic oscillator as a filter, you would have avoided these two losses.

In the middle of the picture you can see two vertical lines. The both mark the spot where the trend reversed. Using stochastic oscillator, you could have filtered and seen that the price would eventually go back down. How easy, isn’t it?

Case 2:

Case 2: Stochastic indicator confirms continuing trend

In the second case, as you can see above, you can see the price once sharply go up and secondly plummet (both highlighted by vertical line).

The stochastic indicator shows that in one case the price is oversold and in the second, overbought. There is nothing easier than to follow the trend of buying or selling traders. If you follow the current trend, you will surely profit.

The signal in case 1 is even stronger because it was boosted by the BERSI Scalp arrow. I strongly recommend you to put Scholastic indicator in your arsenal.

More information

My personal recommendation is not to use the stochastic oscillator as the only signal for opening a trade. However I do recommend it for filtering. If you are about to open a trade, seeing some formation in the chart (or a signal in another strategy), you should first look what the stochastic indicator indicates. If the indicator does not confirm the move in your direction do not go for it. Instead, wait for a while for the next signal.

Thanks to filtering you can separate the good and the bad signals only to trade when the signal is strong enough i.e. to confirm by multiple indicators. The stochastic indicator is not the only indicator one should use as a filter. You can also use the ADX Indicator or RSI.

Further reading

Stochastic oscillator (stockcharts.com – more “scientific” explanation of indicator)
Binary options strategy that works (best binary options strategy.com – one of good TA strategies using stochastic oscillator)
Confirming rebound by indicators (xbinop.com)

Author

More about the author Step

I’ve wanted to build a business of some kind and earn money since I was in middle school. I wasn’t very successful though until my senior year in highschool, when I finally started to think about doing online business. Nowadays I profitably trade binary options full-time and thus gladly share my experiences with you. More posts by this author

Worden Stochastics

What Is the Worden Stochastic?

The Worden Stochastics indicator represents the percentile rank of the most recent closing price compared to all of the other closing values over a specified lookback period. Traders use the indicator to determine if a particular security is overbought or oversold, to provide trade signals, and spot divergences which could signal a price reversal.

Key Takeaways

  • The Worden Stochastic is different from other stochastics in that it ranks closing prices, assigning a value based on where the recent close ranks compared to prior closes.
  • Like other stochastics, the Worden version provides overbought and oversold levels, as well as potential trade signals using signal line crossovers.
  • A reading above 80 is considered overbought, while a reading below 20 is considered oversold. This isn’t necessarily a reason to buy or sell. It just indicates the price is in the upper or lower portion of its recent closing price range.

Understanding Worden Stochastics

The Worden Stochastics indicator was designed by Peter Worden to recognize a new trading range more quickly than traditional stochastics​. Unlike traditional stochastics that incorporate high, low, and closing prices, the Worden Stochastics indicator uses rankings to avoid over-weighting in outlier periods, providing a potentially more accurate indication of the trading range.

The Worden Stochastic is calculated using the equation: (100/n – 1) x Rank. “N” represents the number of closing values in the range, while “Rank” represents the position of the closing price on a list that’s sorted in ascending order by value.

All stochastic indicators, including Worden Stochastics, measure the level of the close relative to the range over a period of time. Traders use these readings to determine if a particular security is potentially trading at overbought or oversold levels.

Trading with the Worden Stochastics

In general, stochastic readings above 80 are considered overbought, while readings below 20 are considered oversold. However, traders should try to confirm these sentiments with other technical indicators or chart patterns. Overbought doesn’t necessarily mean it is time to sell, nor does oversold necessarily mean it is time to buy. In a strong price uptrend, the stochastics readings will often reach above 80. In a strong downtrend, the readings will often be below 20.

The stochastic typically includes a signal line. When the stochastic crosses above the signal line, some traders use that as a buy signal. When the stochastic crosses below the signal line, that is a potential sell signal. Combining that concept with the ones discussed above, a potential strategy would be to look for a stock (or another asset) in a rising trend. Then, wait for the Worden Stochastic to fall below 30 or 20. When the stochastic crosses back above the signal line, or moves up and out of oversold territory, consider a purchase. This is not a strategy recommendation, just an example.

In addition, traders may look for bullish or bearish divergences between the security’s price and stochastics trends. If the price is making higher peaks while the stochastic is making lower peaks, that could signal a potential downside reversal in the price. If the stochastic is making higher lows while the stock is making lower lows, that is bullish divergence and indicates a potential turnaround in the price. Divergence is not a reliable timing signal. It should only be used in conjunction with other analyses and trade signals.

Real-World Example of How to Use the Worden Stochastics

This Worden Stochastics example utilizes 12, 3, and 5 (signal line in blue) default settings, carving three complete Disney buy and sell cycles over a four-month period.

The indicator reverses higher at the oversold level in April, but the price continues to chop sideways to lower in quiet price action. The indicator dips lower in early May, posting a double bottom reversal that translates into a rally wave lasting nearly three weeks.

A mid-May crossover initiates a new sell cycle as the price pulls back to test new price support near 100. The indicator turns higher in early June as the price moves toward a new high. As the price transitions back down, there is a bearish crossover and the stochastics slips back into oversold territory in late June. The overall trend is up at this point, so the next bullish crossover above the signal line could have been used to initiate a long trade near the start of July.

The price and indicator ascend. The indicator remains in overbought territory for much of July and early August. Any of the bearish crossovers could be used as sell signals. A drop below 80 by the stochastics could also be used as a sell signal.

The Difference Between the Worden Stochastics and the Stochastic Oscillator

The Worden variant differs from other stochastics, whether the fast or slow versions, via the way it is calculated. Most other stochastic indicators are comparing the recent closing price to high and low values over a specified period. Worden ranks the close relative to other closing values and then uses that rank in the calculation.

Limitations of Using the Worden Stochastics

The indicator is prone to providing numerous faulty signals. For example, the indicator will stay in oversold or overbought territory for extended periods of time during a downtrend or uptrend, respectively.

There are also multiple crossovers with the signal line that don’t result in significant price moves. Additionally, price divergence with the indicator is not a reliable timing signal.

Learn How To Use The Stochastic Indicator Step By Step

Learn How To Use The Stochastic Indicator Step By Step

I am always astonished that many traders don’t really understand the indicators they are using. Or, even worse, many traders use their indicators in a wrong way because they have never taken the time to look into it. In this article, I will help you understand the STOCHASTIC indicator in the right way and I will show you what it does and how you can use it in your trading.

What is the Stochastic indicator?

The STOCHASTIC indicator shows us information about momentum and trend strength. As we will see shortly, the indicator analyses price movements and tells us how fast and how strong the price moves.

This is a quote from George Lane, the inventor of the STOCHASTIC indicator:

“Stochastics measures the momentum of price. If you visualize a rocket going up in the air – before it can turn down, it must slow down. Momentum always changes direction before price.” – George Lane, the developer of the Stochastic indicator

What is momentum?

Before we get into using the Stochastic, we should be clear about what momentum actually is.

Investopedia defines momentum as “TheВ rateВ ofВ accelerationВ ofВ theВ priceВ ofВ aВ security.” viaВ Investopedia

I am always a fan of going into how an indicator analyzes price and without getting too deep into the mathematics, this is how the indicator analyzes price:

The stochastic indicator analyzes a price range over a specific time period or price candles; typical settings for the Stochastic are 5 or 14 periods/price candles. This means that the Stochastic indicator takes the absolute high and the absolute low of that period and compares it to the closing price. We will see how this works with the following two examples and I have chosen a 5 period Stochastic which means that the Stochastic only looks at the last 5 candlesticks.

Example 1: AВ high Stochastic number

When your Stochastic is at a high value, it means that price closed near the top of the range over a certain time period or number of price candles.

The graphic shows that the low was at $60, the high at $100 (range of $40) and price closed almost at the very top at $95. The Stochastic shows 88% which means that price only closed 12% (100% – 88%) from the absolute top.

How a high Stochastic is calculated:
The lowest low of the 5В candles: $ 60
The highest high of the 5В candles: $ 100
The close of the last candle: $95
The value of the Stochastic indicator: [(95 – 60 ) / (100 – 60)] * 100 = 88%

You can see, the high Stochastic shows us that price was very strong over the 5В candle period and that the recent candles are pushing higher.

Example 2: AВ low Stochastic number

Conversely, a low Stochastic value indicates that the momentum to the downside is strong. In the graphic we can see that price only closed $5 above the low of the range at $50.

How a high Stochastic is calculated
The lowest low of the 5 candles: $ 50
The highest high of the 5 candles: $ 80
The close of the last candle: $55
The value of the Stochastic indicator: [(55 – 50 ) / (80 – 50)] * 100 = 17%

The Stochastic of 17% means that priceВ closed only 17% above the low of the range and, thus, the downside momentum is very strong.

Overbought vs Oversold

The misinterpretation of overbought and oversold is one of biggest problems and faults in trading. We’ll now take a look at those expressions and learn why there is nothing like overbought or oversold.

The Stochastic indicator does not show oversold or overbought prices. It shows momentum.

Generally, traders would say that a Stochastic over 80 means that the price is overbought and when the Stochastic is below 20, the price is considered oversold. And what traders then mean is that an oversold market has aВ high chance of going down and vice versa. This is wrong and very dangerous!

As we have seen above, when the Stochastic is above 80 it means that the trend is strong and not, that it is overbought and likely to reverse. A high Stochastic means that the price is able to close near the top and it keeps pushing higher. A trend where the Stochastic stays above 80 for a long time signals that momentum is high and not that you should get ready to short the market.

The image below shows the behavior of the Stochastic within a long uptrend and a downtrend. In both cases, the Stochastic entered “overbought” (above 80), “oversold” (below 20) and stayed there for quite some time, while the trends kept on going. Again, the belief that the Stochastic shows oversold/overbought is wrong and you will quickly run into problems when you trade this way. A high Stochastic value shows that the trend has strong momentum and NOT that it is overbought.

The Stochastic signals

Finally, I want to provide the most common signals and ways how traders are using the Stochastic indicator:

  • Breakout trading: When you see that the Stochastic is suddenly accelerating into one direction and the two Stochastic bands are widening, then it can signal the start of a new trend. If you can also spot a breakout out of sideways range, even better.
  • Trend following: As long as the Stochastic keeps crossed in one direction, it shows that the trend is still valid.
  • Strong trends: When the Stochastic is in the oversold/overbought area, don’t fight the trend but try to hold on to your trades and stick with the trend.
  • Trend reversals: When the Stochastic is changing the direction and leaves the overbought/oversold areas, it can foreshadow a reversal. As we’ll see, we can also combine the Stochastic with aВ moving average or trendlines nicely.
    • Important: when we look for a bullish reversal, we need to see the green Stochastic line to get above the red one and leave the overbought-oversold area.
  • Divergences: As with every momentum indicator, divergences can also be a very important signal here to show potential trend reversals, or at least the end of a trend.

Combining the Stochastic with other tools

As with any other trading concept or tool, you should not use the Stochastic indicator by itself. To receive meaningful signals and improve the quality of your trades, you can combine the Stochastic indicator with those 3 tools:

  • Moving averages: Moving averages can be a great addition here and they act as filters for your signals. Always trade in the direction of your moving averages and as long as price is above the moving average, only look for longs – and vice versa.
  • Price formations: As breakout or reversal trader, you should look for wedges, triangles and rectangles. When price breaks such a formation with an accelerating Stochastic, it can potentially signal a successful breakout.
  • Trendline: Especially Stochastic divergence or Stochastic reversal can be traded nicely with trendlines. You need to find an established trend with a valid trendline and then wait for price to break it with the confirmation of your Stochastic.

Recap: How to use the Stochastic indicator

You might not need the Stochastic indicator when you are able to read the momentum of your charts by looking at the candles, but if the Stochastic is the tool of your choice, it certainly does not hurt to have it on your charts (this goes without a judgment whether the Stochastic is useful or not).

More importantly, this article is meant to make you realize how little you might know about the tools you use for your trading. Additionally, there is a lot of wrong knowledge being shared among traders and even widely used tools such as the Stochastic indicator is often misinterpreted by the majority of traders. Do not blindly believe what other people tell you, do your own research and build your trading knowledge.

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