Ever wonder how you can use speed of price and find a quantified indicator to tell you how the momentum is fairing? This is what the stochastic oscillator does, it assumes strength lies in momentum and compares the current close against the previous high low of the previous 14 days (or any other period you choose).
Like all indicators you can increase the sensitivity of the stochastic oscillator by reducing the period from the default 14 to something lower. However it is always best to test the oscillator on default values and on higher time frames like the hourly and above for best results.
%K = (Current Close – Lowest Low14)/(Highest High14 – Lowest Low14) * 100
%D = 3-day SMA of %
Lowest Low14 = the low of the 14 previous trading sessions
Highest14 = the highest price traded during the same 14-day period.
This calculation gives the stochastic indicator, also called the %K. For a trigger, very frequently traders use a 3 SMA of the %K indicator itself, we call this the %D. These two lines allow us to use crossovers to put on a trade, but traders necessarily do not use crossovers to initiate trading positions.
%D = 3-period moving average of %K
The Stochastic itself is plotted on the assumption that in uptrends the close is usually higher in the range. The same is assumed to be true in downtrending markets, that the close is usually lower than the average range.
There are oversold and overbought levels of the indicator and can be used to initiate the trade.
In the chart below we have marked a stochastic 14 period at the bottom of the chart. Additionally we have added an overbought line at 80 and an oversold line at 20. When prices cross the top line (80) then the market it said to be overbought and is likely to fall given the correct circumstances.
This is the same chart of Bajaj Auto, daily timeframe, except this time we have marked every time the market went below the 20 point region which meant the market is oversold and is likely to witness a price rise given the correct circumstances.
Do you use the stochastic differently? Do share with us your way of doing things by writing to us.