How to Trade Cryptocurrency Using a Stochastic Indicator
The stochastic indicator, or stochastic oscillator, is one of the most popular technical analysis tools in crypto trading. Even so, most traders don’t really understand how to use it. And that's because there’s more to understanding and utilising this indicator than meets the eye.
In this post, we will explore everything you need to know about this indicator and how to use it correctly under different market conditions.
First, What is a Stochastic Indicator?
The word Stochastic originates from a Greek term meaning ‘guess'. When used in the context of trading, it means using past actions to determine the future. Oscillator refers to variations up or down the equilibrium position.
A stochastic oscillator is a momentum indicator that compares the closing price of a crypto asset to its price range over a specific period. As such, this indicator shows you information about trend strength and momentum. It analyses prices and enables you to determine how strong and fast the price is moving.
The stochastic indicator was invented by George Lane, who said the following:
"Stochastics measures the momentum of price. If you visualise a rocket going up in the air - before it can turn down, it must slow down. Momentum always changes direction before price."
Stochastic indicators analyse the price range over a specific period of candles. The most common settings for stochastics are 5 and 14 price candle or time periods.
This simply means that the stochastic indicator takes the highest high and the lowest low of the period in question and compares it to the closing price. The period each trader chooses here would depend on their goal; are they wanting to analyse the market short-term, mid-term, or long-term?
How are Stochastics Calculated?
The formula for calculating stochastics is rather simple, especially when compared to other more complex technical indicators.
As you can see in the graph, stochastic indicators are drawn from two different lines that represent %K and %D values. These values are calculated using the following formulas:
%K = (closing price of current bar-lowest price of calculating period) / (highest price of calculating period - lowest price of calculating period) × 100
%D = the 3-period simple moving average of %K or 100 × ((K1 + K2 + K3) / 3)
Different charting platforms use different stochastic oscillator settings. Hence, you should always check to confirm the number of periods your preferred charting platform is using.
If you are just getting started with cryptocurrency trading, it would be a good idea to stick to using the 14-period setting. If you are more experienced, spend some time testing a cryptocurrency pair and try to find an ideal time range you can use to calculate the stochastic oscillator values for that particular cryptocurrency pair.
How do you use the stochastic oscillator effectively?
The stochastic indicator is plotted on a fixed scale. Its values stay in the range of 0 to 100. This oscillator offers three main types of signals:
- Overbought (OB) and oversold (OS)
- Stochastic divergence
- Stochastic crossover
When using this indicator, some of the most significant faults emanate from the misinterpretation of the words overbought and oversold. Let’s examine the meaning of these two terms and learn why there is nothing like overbought or oversold.
The stochastic indicator shows momentum, not oversold or overbought.
When a stochastic is over 80, traders say that it overbought and when it is below 20, they say it is oversold. What traders usually imply here is that an overbought market has a high likelihood of going bearish and an oversold market is likely to go bullish. This interpretation is not only wrong but also dangerous.
A stochastic of above 80 is an indication of a strong uptrend. It is not a sign that the market is overbought and likely to reverse. A high stochastic indicator shows that the price keeps pushing higher and that it can close near the top. When the stochastic remains above 80 for an extended period, it shows that the momentum is high. It is not necessarily a sign that you should short the market.
For instance, have a look at the image below. The market prices got into the overbought zone and stayed there for quite some time, without the market trends reversing. As you can see, you may quickly run into trouble if you execute trades based solely on overbought/oversold basis.
How Should You Interpret Stochastic signals?
In the subsequent sections, we will discuss standard stochastic signals in various market conditions and some of the ways traders are using the stochastic indicator:
- Breakout trading
If you check your charts and notice a sudden acceleration of stochastics in the same direction accompanied by a widening of two stochastic bands, this is an indication of the beginning of a new trend. The signal is even more accurate if you can identify a breakout out of a sideways range.
- Trend following
Provided that the stochastic remains crossed in one direction, it signifies that the trend is still valid. For instance, in a strong downtrend, don’t fight the trend; take trades only in the direction of the trend every time the stochastic is in the overbought zone.
- Trend reversals
The stochastic changing its direction and leaving the oversold or overbought area can be a sign of a reversal. It is essential to keep in mind that when looking for a bullish reversal, you have to see the green stochastic line getting above the red one and leaving the oversold area.
Divergence also goes a long way in signalling trend reversals. They are also used to show the end of a trend.
Just like other trading tools, you should never rely on the stochastic indicator alone. Therefore, to receive meaningful signals and improve the quality of your trades, it's vital that you combine the stochastic indicator with the following tools:
- Moving averages
Moving averages can be a critical addition to the stochastic indicator. They act as filters for your signals. In a trending market, always trade in the direction of the moving average.
- Price formations
As a reversal or breakout trader, you should always be on the lookout for rectangles, triangles, and wedges. A successful breakout is likely to occur when the price breaks such a formation with an accelerating stochastic.
Trendlines can be nicely traded with stochastic reversals and stochastic divergence. You have to find an established trend and a valid trendline and wait till the price breaks it with the formation of a stochastic.
About the author:
Jay Jackson is a blockchain enthusiast and a freelance writer at topcryptowriter.com. He works closely with brands (people, businesses and startups) in the crypto sphere. He currently writes Blog posts, Guides, Press releases, ICO reviews, eBooks & Whitepapers. You can find him on LinkedIn.
The above references an opinion and is for informational purposes only. Do not take this as personalised financial or investment advice. The views expressed by the author do not necessarily represent the opinion of BitPrime.
Last updated: 27/08/2019