Stochastic Indicator: How it Works and How You Can Use it | Beginner’s Guide to the Stock Market | Module 20

Stochastic Indicator is one of the most useful indicators in Technical Analysis. A Stochastic Indicator is used to check the momentum of the particular stock. It is an oscillator that oscillates between a fixed range of values.

Through this article, we are going to see how the exactly Stochastic Indicator works and how we can use it, to enhance our profitability.

Stochastic Indicator & Its calculation

The Stochastic Indicator gives us information about the market momentum by taking into account factors like the recent price of that stock and its previous range that includes swing highs and swing lows.

The Stochastic Indicator is made up of 2 lines. Line 1 is called as %K line and 2nd line is called as %D line which is 3 days simple moving average of %k.

Calculation of these two lines are given below –

Where-

C = Recent Closing Price

HP14 – Highest Price in previous 14 days.

LP14 – Lowest Price in previous 14 days.

%D line =

In short %D is the SMA of %K.

Generally, traders follow the %D line closely as it is moving average of %K. You don’t need to do all these calculations to use the Stochastic Indicator. The software will do everything for you.

How to use Stochastic Indicator?

Now, the question arises, how we can use Stochastic RSI to improve our trading. As mentioned before, while using Stochastic Indicators traders give more attention to D line.

Stochastic Indicator oscillates between 0 to 100. Out of 2 lines, %K line is faster than %D line. When the D lines reach the overbought zone i.e above 80 then traders look for selling opportunities. Similarly, When the D line moves below 20 then that zone is called an oversold zone, and there, traders look for buying opportunities.

One more important point to note here is, Traders should take confirmation from other indicators or price action before taking the entry. Only a Stochastic Indicator can’t be used to decide the entries and exits of the trade.

Example of the Stochastic Indicator–

As shown in the above example, when the D line is in the overbought zone, sell entries can be initiated. When the stock goes down and the D line reaches below the 20 mark, the buy entries can be initiated as shown in the figure.

Advantages and limitations of the Stochastic Indicator.

A Stochastic Indicator is a very useful indicator in technical analysis.

• Here are the advantages of Stochastic Indicator-

It is the simplest indicator to use in the whole bunch of Indicators, Generally, every indicator needs a bit of setting modification but we can use a stochastic indicator without changing its default settings.

One more advantage of the Stochastic Indicator is, Signals generated by the indicator are reliable and easily spotted in the live markets. Also, signals spotted by the Stochastic Indicator can offer great risk to reward ratios to trade.

2) Limitations of Stochastic Indicator-

As every indicator has some limitations, here are some of the limitations of Stochastic Indicator –

As I mentioned before, the Only Stochastic Indicator can not be used for taking the entry or exit. You need confirmation from other indicators or from price action in order to make a conclusive decision.

Also, Once the Stochastic Indicator reaches the Overbought or Oversold zone, there is no specific rule that it has to come to its mean immediately because there is a possibility that the stock can consolidate in its overbought and oversold zone and then makes the move. So, in that case, the stochastic will stay in an overbought or oversold zone as long as the stock is consolidating in a specific range. These are the few limitations of the Stochastic Indicator.

I hope that through this article, I was able to explain to you what exactly is Stochastic Indicator & How We Can Use It to get an idea about the momentum of the stock. If you are interested in learning more about different indicators used in the technical analysis, you can definitely check out my blog on Average True Range Indicator: How it works & How You Can Use it | Beginner’s Guide to the Stock Market | Module 15. If you have any queries regarding this topic, please post them in the comment section.

If you want to know more about Risk Management & Intraday Trading Strategies you can refer to our previous blog on

Importance Of Risk Management In Trading and 10 Best Intraday Trading Strategies.

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Happy Learning!