Developed in the late 1950s by George Lane, the Stochastics indicator is one of the most popular ones out there, used by many traders in a variety of way. The stochastics indicator measures the relationship between the closing price of an instrument and its price range of a specific period of time. It’s a favorite among the community given its ease of reading and use yet mastering it could mean many hours of understanding the price outcome of its different patterns.
The indicator is made up of two lines that intersect each other depending on the closing prices and whether the market is up or down. Consecutively higher prices will see the stochastics crossing upwards and trending higher while lower closing prices will see the indicator crossed downward and moving lower. This is the first part that traders examine when using the indicator to spot reversals.
The other and main use of the indicator is its ability to help spot overbought or oversold conditions. Given that it fluctuates between 0 and 100, the indicator tends to find overbought conditions above 70-80 and oversold conditions below 30-20. Such levels could trigger reversals in an ideal scenario yet it’s not always the case and the market could continue its initial direction if momentum is strong enough.
Putting the two together, traders may look for overbought or oversold conditions and then a crossover in the opposite direction to indicate that the market is ready to reverse (figure 1 – green ellipses). The crossover is of higher quality once it crosses below the 80 threshold or above the 20 level.
It’s important to keep an eye on powerful trends with strong momentum as the stochastics indicator can give many false signals (figure 2). In this case, traders can do different things to filter out such as looking at a higher timeframe or filtering with the use of a moving average that could help determine the current trend if it’s unclear for the trader.
Finally, regardless of how confident you are in a certain indicator and its signals, it’s important to keep in mind levels of support and resistance as well as price patterns. The indicator could be signaling a reversal when price may be in a congested area, lowering the odds of success of the signal generated by the Stochastics.
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