These oscillators are based on two fairly straight forward observations. In an uptrend, today’s closing price is likely to be close to the highest value recorded over the last few days. Conversely, in a downtrend, today’s closing price is likely to be close to the lowest value recorded over the last few days. As with all oscillators, the exact number of days (parameter) is set by the user.
In the chart above, the top oscillator is a stochastic and the bottom oscillator is a slow stochastic.
Unlike the RSI, the stochastic oscillator displays two lines and a slow stochastics is “double-smoothed” – this means that there are 3 steps to calculate the three slow stochastic lines.
- %K = Percentage Alert Line
- %D = Percentage Definite Line
- %Dn = Percentage Definite Signal Line
%K represents a measure (on a percentage basis) of where the last closing price lies within the price range of a chosen period. So if the latest closing price is at the high of the last 10 events, then %K = 100% and is it’s currently trading at a 10-event low, then %K = 0%.
As you can see, the fluctuations of %K can be extremely volatile, hence the reason for smoothin this line not once (%D) but twice (%Dn).
NOTE: Slow stochastics (%D & %Dn) are used for market analysis, not simple stochastic (%K & %D).
For a 10-6-6 slow stochastic:
- Ct = Current price, or latest closing price
- L10 = Lowest low for the last 10 events
- H10 = Highest high for the last 10 events
Hence a closing price near or equal to the top of the 10-event price range will give a high value to the %K line, while a close near or equal to the bottom of the price range will give a low reading.
- H6 is the 6-event sum of (Ct – L10)
- L6 is the 6-event sum of (H10 – L10)
- Usually 75% and 25% values are used to identify overbought and oversold situations, although some traders prefer 80/20% (for strong trending markets) or 70/30% (for gentle trending markets, or simply to increase the amount of time spent in the (more interesting) overbought and oversold zones.
- Bullish and bearish divergences are observed the same way as with the RSI.
- The signal to watch for is a divergence between the %D line and the underlying price when the %D line is in the overbought (or oversold) zone.
- A sell signal is given when %D crosses below %Dn in the overbought zone (ideally on the 2nd entry into the overbought zone as the stochastic os creating bearish divergence with the price).
- A buy signal is given when %D crosses above %Dn in the oversold zone (ideally on the 2nd entry into the oversold zone as the stochastic is creating bullish divergence with the price).
- Slow stochastic trading signals should always be confirmed by a trading signal from a primary indicator.
- When confirmation is given this signal is usually strong and accurate.
How to Trade with a Stochastic
You now understand how the stochastic and slow stochastic works but how to you trade with it?
Given the above, we prefer to utilise the slow stochastic in ranging markets. Similarly to any secondary indicator, the slow stochastic must be used in conjunction with a primary indicator. You should not take a trade solely on just a signal from the slow stochastic.
Using a Stochastic in a ranging market
The stochastic is to confirm that the range is in fact a range. Firstly you need to identify the range using support and resistance, next you confirm that at the bottom of the range the stochastic is oversold and at the top of the range the stochastic is overbought.
Confirming the Range:
- Support and resistance should be tested twice on both sides.
- The slow stochastic should confirm this by being overbought at the resistance and oversold at the support
Once confirmed, it is simply a case of buying at the support and selling at the resistance.
Preferred slow stochastic settings to confirm the range are:
- %K = 14
- %D = 7
- %Dn = 7
Using a stochastic as a trigger
As the example above shows, you can also use a stochastic to enter a trade. You must not use the stochastic on its own to enter the market but wait for a primary signal and then the stochastic can confirm this.
The example above shows that the market held on a support line and also had a bullish candlestick formation. Both these signals are primary signals and reason enough to take the trade. The additional slow stochastic buy signal (line cross and leaving over sold zone), confirms that the trigger is valid, you can now hit the trigger and take the trade.