Stochastic - Measuring Price Position as a Percentage

What is the Stochastic Oscillator

The Stochastic Oscillator is a momentum indicator developed by George Lane in the 1950s. The core concept is simple yet insightful.

In uptrends, closing prices tend to be near the top of the recent price range; in downtrends, closing prices tend to be near the bottom of the recent price range.

In other words, the Stochastic shows where the current closing price sits within the recent price range as a percentage. At 0%, the close is at the period's lowest price; at 100%, it's at the period's highest price.

This concept is intuitive. If Bitcoin traded between $40,000 and $50,000 over the past 14 days, and today's close is $48,000, the close is at the 80% level of the entire range. In this case, the Stochastic value would be approximately 80.

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%K Line and %D Line

The Stochastic Oscillator consists of two lines.

%K Line (Fast Line)

%K is the main line, representing the current closing price's relative position.

%K = ((Current Close - Lowest Low over N periods) / (Highest High over N periods - Lowest Low over N periods)) x 100

The default period is 14 days. This value oscillates between 0 and 100.

%D Line (Slow Line)

%D is a moving average of %K. Typically, a 3-day simple moving average (SMA) of %K is used.

%D = 3-day SMA of %K

Since %D smooths out %K, it moves more gradually. The crossover between %K and %D generates trading signals, with %D serving as a signal line. This relationship is similar to the MACD line and signal line in MACD.

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Fast Stochastic vs Slow Stochastic

There are two versions of the Stochastic. Understanding this difference is important.

Fast Stochastic

This is the Stochastic using the basic formula described above. %K reacts very sensitively to price, moving rapidly. Because of this, the line fluctuates sharply with significant noise, so it's rarely used in practice.

Slow Stochastic

This is the version most commonly used in practice. It uses the Fast Stochastic's %D as the new %K, and the new %K's 3-day moving average as the new %D.

• Slow %K = Fast %D (i.e., 3-day SMA of Fast %K)
• Slow %D = 3-day SMA of Slow %K

Slow Stochastic has smoother movement compared to Fast, reducing false signals. On most charting platforms, "Stochastic" defaults to the Slow Stochastic.

Default Settings

The standard Stochastic settings are (14, 3, 3).

• 14: %K calculation period (last 14 candles)
• 3: %K smoothing period (Slow %K)
• 3: %D smoothing period

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Overbought and Oversold Zones

Like RSI, the Stochastic provides overbought/oversold zones.

Note that Stochastic uses 80/20 thresholds compared to RSI's 70/30.

However, like RSI, it's risky to immediately sell when entering the overbought zone or immediately buy when entering the oversold zone. In strong trends, the Stochastic can remain in overbought or oversold territory for extended periods.

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Trading Signals

Crossover Signals

The basic trading signals from the Stochastic come from %K and %D crossovers.

Buy Signal:

1. Both %K and %D are in the oversold zone (below 20).
2. %K crosses above %D from below.
3. Both lines then rise above 20.

Sell Signal:

1. Both %K and %D are in the overbought zone (above 80).
2. %K crosses below %D from above.
3. Both lines then fall below 80.

Crossovers occurring outside the overbought/oversold zones have low reliability and require caution.

Divergence

Divergence can also occur with the Stochastic. If price makes a new low but the Stochastic makes a higher low, it's bullish divergence. If price makes a new high but the Stochastic makes a lower high, it's bearish divergence.

50 Line Crossover

When %K crosses above the 50 line, bullish momentum dominates; when it crosses below, bearish momentum dominates. This can be used as supporting evidence for judging medium-term directional changes.

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RSI vs Stochastic Comparison

Both RSI and Stochastic are momentum oscillators, but they measure different things.

Which One to Use

You don't have to choose only one. When both indicators simultaneously show overbought or oversold, signal reliability increases. However, using two similar indicators can create redundant information, so it's more effective to choose one momentum indicator and combine it with trend indicators (MACD, ADX) or volatility indicators (Bollinger Bands).

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Strengths and Limitations

Strengths

• Leading indicator nature: The Stochastic tends to move before price reversals, useful for catching turning points early. This contrasts with lagging indicators like moving averages and MACD.
• Useful in ranging markets: Overbought/oversold signals work well when price oscillates within a range.
• Clear crossovers: The visual clarity of %K and %D crossovers makes it easy to determine entry and exit points.

Limitations

• False signals in trending markets: In strongly trending markets, the Stochastic can remain overbought or oversold for extended periods, repeatedly generating premature reversal signals. Following these signals means missing most of the trend.
• Sensitive to noise: Fast Stochastic especially reacts significantly to small price fluctuations, generating many false signals.
• Not suitable for standalone use: Like all technical indicators, making trading decisions based on the Stochastic alone is risky.

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Practical Tips

1. Use Slow Stochastic: The Fast version has too much noise for practical trading.
2. Confirm trend first: When ADX is above 25 indicating a trending market, don't use Stochastic overbought/oversold signals for counter-trend trading. Instead, use them for trend-direction pullback entries.
3. Only crossovers within overbought/oversold zones are valid: Crossovers in the neutral zone (20-80) have low reliability.
4. Check multiple timeframes: Confirm trend direction on higher timeframes (daily, 4-hour), then use Stochastic signals on lower timeframes for entry timing.
5. Combine with support/resistance: Stochastic signals near major support or resistance levels have higher reliability.

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Next article: CCI - How Far from the Average