What is Stochastic Indicator?

The Stochastic indicator shows price momentum, creating a basis for investors to find trend reversal points.

Stochastic is a popular indicator in technical analysis that compares closing prices with a range of prices over a certain period of time, thereby showing price momentum.

This indicator is composed of 2 components, %K and %D lines. In which, %K is the main line and %D is the 3-session moving average of the %K line. The formula to calculate %K is as follows:

In there:

- C is the nearest closing price

- L14 is the lowest price in 14 sessions

- H14 is the highest price within 14 sessions

Since the %D line is generated from %K, the %K line will be the faster line, while the %D line will be the slower one.

The most commonly used timeframe is 14 sessions. However, investors can customize the timeframe accordingly.

Besides, this indicator also has 2 border lines 20 and 80 to determine the overbought and oversold thresholds.

If the indicator crosses the 80 border, it shows that the security is in overbought condition. This also warns the uptrend is likely to be reversed.

And if the indicator exceeds the 20 border, it shows that the security is in oversold condition and also a sign that the price may be nearing the bottom, preparing to turn up.

Depending on the trading strategy, investors can adjust the indicator, setting 25 and 75 or 30 and 70 as oversold and overbought levels instead of 20 and 80.

Based on the Stochastic indicator, it is found that when the %K line crosses the %D line from below, it is a bullish signal. This is the time when investors consider buying. Conversely, when the %K line crosses the %D line from above, signaling that the price is on the way down, investors consider selling.

In addition, the Stochastic indicator also provides a signal through the divergence between the %K line and the stock's price movement.

When the price is making a lower low but the %K line is making a higher low, this is a signal of a bullish divergence, investors should consider selling the stock.

When the price is making a higher low but the %K line is making a lower low, this is a signal of a bearish divergence, signaling a reversal from bearish to bullish, investors consider buying stocks.

As with all technical indicators, Stochastic also has limitations in its analysis. In some cases, the indicator continuously remains in the oversold or overbought zone for a long time, creating false signals that confuse investors.

To use Stochastic effectively and proficiently requires investors to be flexible with the market, update quickly as well as choose reasonable time frames. At the same time, investors should use it in combination with other analytical tools to make the most accurate decisions.