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Stochastic Oscillator consists of two lines called %K and %D. The core of this indicator is the %K and%D itself is SMA of %K. It can be said that the %D line is identifying the direction of %K.
If we see the range of 0-100 that is Stochastic Oscillator, it can be said that this indicator was not different from the RSI. The difference is, in Stochastic calculation includes the lowest price, and the highest closing price in the period specified. Let's see the picture below.
The picture above is the Stochastic Oscillator for GBPUSD with the daily candlestick period. It appears that %D curve is smoother compared to the curve of %K. One typical indicator of this is its movement which always have the range of 0-100. By the way, in the picture above, the Stochastic Slow from Netdania is used. Later you will learn that the Stochastic Oscillator itself has many variants such as the fast and slow.Now, How do I use this indicator? Is it the same as RSI? If it's same, why don't we just use RSI? That question will be answered in this lesson.
Stochastic is in the same type as RSI, that's indicator typed Oscillator. The use of this kind of indicator model is to accommodate the movement overbuy and oversold area from the currency movements. However, there are some things that Stochastic have but not RSI and also vice versa.
By its sensitivity, RSI is far more sensitive than the Stochastic. So with the ease of reading. RSI does not have a smoother curve, such as the %D in Stochastic. Thus, Stochastic can eliminate bias when reading.
However, simplicity of RSI leading to its drawback. RSI doesn't fit well if we'd like to find out the trend that is in progress. Meanwhile, the combination of %K and %D Stochastic can be powerful enough to predict trends that are happening.
Additionally, Stochastic doesn't as sensitive as RSI so it has less false signal than the RSI. This is why most traders prefer to know Stochastic to determine overbought or oversold condition of the market.
There is some information that we obtain with the Stochastic Oscillator. However, in general, they're not different from the information on the RSI and SMA. The Stochastic Oscillator is actually a combination of both types of indicators with different calculations. Overall, this indicator can be used to determine the overbought / oversold (which means the predicted trend for the long term), crossover between %K and %D (as a short term trend signals), and the Bullish / Bearish centerline.
Overbought / Oversold
The state of overbought / oversold according to the Stochastic happen when %K line has passed the limits of 20 and 80. Below 20 for oversold, and above 80 for overbought. Same as RSI, isn't it? Please note that this 20/80 restriction is not an absolute limits. It could be 30/70 or the others.
The state of overbought / oversold this will trigger the movement of price in the long term. If the price increases, but the stochastic was moving to the overbought-point and began leaving the area, that means there will be pressure on the increasing price that will make the price back down until it's balanced. Note the picture below. Limits for overbought / oversold we used is 20/80 (colored with orange).
From the picture seen above, we'll see when the price has gone into OB or OS area, then it will move back down according to the movement direction of Stochastic. How many times Stochastic indicates that its extraordinary accuracy in determining the direction of price movement (marked with red circle). By following the Stochastic itself we can see how much profit that can be generated in a few days the movement.%K and %D Crossing
In addition to the area 20/80 as in the example above, crossover between %D and %K can be used to determine the position of a Buy / Sell. Sometimes we run out of patience waiting for the Stochastic to reach 20/80 limit as we specify. Although often accurate, but when Stochastic moves down, it's sometimes not enter the area of 20, or vice versa. Sometimes, before prices go through the overbought/oversold area, it has already returned to the opposite direction so that we lose an opportunity. Crossing Stochastic can be used to determine Buy / Sell position in this circumstances.
Similar to the Moving Average indicator used by crossing in two different periods, the same can also be applied on Stochastic. The difference here is that there is a crossing between the %K and %D(which is the smoother of %K).
As we know before, that %D is MA from the %K (which is another reflection of price changes). So, according to the nature of MA in determining trend changes, each crossing between the %D and %K means that current trend is about to change for the short time in the future. Bullish condition occurs when the %K crossing the %D from the bottom, and vice versa. Bearish trend obtained when %K crossing from the top. This condition could be happened even if both line are in the overbought / oversold region. If this happens, that means the pressure to buy or sell are very strong, so there will be a possibility of prices penetrate its support or resistance. Pay attention to the picture below:
When the %K and %D crossed each other and started to move up (marked yellow), the price also shows uptrend and continue to move up. Conversely when the price moves down, %K and %D also crossed each other and have the direction to the bottom (marked with green color). Both condition will continue repeating one after another. How to read it is exactly the same as we interpret the Moving Average indicator.Well, the discussion ends here about the Stochastic Oscillator. Before we move to the other indicators, I'd like to remind about the characteristic of oscillator indicator especially Stochastic. Things that become advantage as well as weakness of this indicators when moving in a certain range is its sensitivity. So with the Stochastic, it can be very sensitive when we use the period that is not appropriate. Use of the period that is not appropriate will take us to a wrong decision that ultimately brings us to the bigger loss. So, it's highly recommended that you search for the best period (to use with the indicator) for each pairs, because it can be vary for each pairs. The longer period being used, more smoother graphic indicator will be. That's means its sensitivity will be reduced.
