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In this section, we will learn about a new indicator known as 'Stochastic.'
What is Stochastic Indicator?
The Stochastic indicator was developed by George Lane. It is a technical analysis indicator which compares where a security’s price closes over a selected number of periods. Most traders use the 14-periods stochastic.
Stochastic Indicator Formula:
It is calculated using the following formula-
%K = 100[(C – L14) / (H14 – L14)]
C = the recent closing price
H14 = the highest price traded during the same 14-day period.
L14 = the low of the 14 previous trading sessions
A %K of 80 implies that the security’s price is above 80% of the price range (high – low) of the last 14 days. The assumption here is that security’s price will remain at the top of the range in a strong uptrend.
The other line i.e. %D line is a three-period moving average of the %K line which acts as a signal line.
Whenever the %K line crosses the %D line, it generates a trading signal.
Normally a period of 14 days is used for the above calculation, but the traders often modify it to 5 or 9 according to their trading strategies.
Slow vs Fast Stochastic Indicator
There is a concept of fast and slow stochastic and the difference basically lies in terms of sensitivity.
The % D line in fast Stochastic is a 3 period moving average of %K line.
This % D line of fast Stochastic is taken as % K line of slow Stochastic, the %D line in slow Stochastic is 3 period moving average of this line.
The fast Stochastic is more sensitive than the slow Stochastic to a change in the price of the underlying security and it will result in more number of trading signals than slow Stochastic.
In the following picture, we have plotted both the slow and fast Stochastic for WTI Crude oil.
Bullish and Bearish Divergence
Apart from identifying overbought and oversold zones, another very important use of Stochastic Oscillator is divergence and it plays a very important role in identifying reversals.
A bullish divergence is seen when the price makes a lower low while stochastic makes a higher low. This shows that the downside momentum is weakening and anytime there can be a reversal on the upside. A bullish divergence is confirmed when the price action becomes bullish along with stochastic continuing uptrend.
On the other hand, a bearish divergence is formed when the price makes a higher high but the stochastic makes a lower high.It suggests that the upside momentum is limited and anytime there could be a reversal on the downside. The confirmation of bearish divergence comes when the price action becomes bearish and stochastic continues to downtrend.
The momentum oscillators work very well in the trading market but it can be used in the trending market as well. Many times, the Stochastic Indicator gives a crossover before reaching the 20 or 80 line and this crossover in the middle is strong confirmation of a change in short-term trend.The accuracy of its findings makes it one of the favorite indicators amongst the technicians.