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​Yes, Give it to me

A Complete Guide to Stochastic Indicator 

 May 17, 2018

By  Rayner

Last Updated on

Let me ask you…

Have you ever looked at a chart and noticed the Stochastic indicator is overbought.

So, you immediately go short because you think the market is about to reverse.

And here’s what happened next…

The market stalls.

Pause for a while.

…and then it blasts off higher!

Clearly, you got stopped out of your trade and you wonder to yourself…

“Wtf just happened?”

Well, you’re not alone.

That’s why I wrote this Stochastic indicator trading guide to teach you everything you must know about Stochastic, how to use it, how NOT to use it, and why.

Here’s what you’ll learn:

Or if you prefer…

You can watch this training video below:

Stochastic indicator explained: What is it and how does it REALLY work

Now:

Instead of me explaining what the Stochastic indicator is about, here’s what the founder of Stochastic has to say…

“Stochastics measures the momentum of price.

If you visualize a rocket going up in the air – before it can turn down, it must slow down.

Momentum always changes direction before price.” – George Lane

In other words:

The Stochastic is an indicator that measures momentum in the markets.

And for you math geeks out there, here’s the formula to calculate it…

%K = (Current Close – Lowest Low) / (Highest High – Lowest Low) * 100

%D = 3-day SMA of %K

Where:

Lowest Low = lowest low for the look-back period

Highest High = highest high for the look-back period

%K is multiplied by 100 to move the decimal point two places

Are you confused?

Yeah, me too!

That’s why this image below will explain better (using an 8 period Stochastic)…

stochastic indicator

Stochastic indicator settings

Now just a quick one.

The settings on my Stochastic indicator is (20, 1, 1) and it’ll show a single line instead of the traditional 2 lines.

Here’s what I mean:

stochastic indicator

Now there’s nothing magical about it.

I use 20-period because there are 20 trading days in a month, and a single line is enough to interpret what it means.

Does it make sense?

Great! Then let’s move on…

2 DEADLY mistakes traders make when using the Stochastic indicator — and how you can avoid it

This is important.

If you can avoid these mistakes, then you’ll save yourself hundreds if not thousands of dollars in the long run.

They are:

  1. Going long just because the market is oversold
  2. Thinking the market will reverse because you spot a divergence

I’ll explain…

1. You go long just because the market is oversold

Recall:

The Stochastic is an indicator that measures momentum in the markets.

So, when it’s at overbought level (above 80), it means the market has strong bullish momentum.

And the last thing you’d want to do is “blindly” go short just because Stochastic is overbought.

Here’s why:

As you can see, if you went short just because the market is overbought, it would have been a painful experience.

Because the market can remain overbought/oversold for a long period of time – far longer than your account can withstand it.

Next, let’s move on to the 2nd deadly mistake made by traders…

2. You think the markets will reverse because there’s a divergence

A divergence occurs when the price makes a higher high but the indicator shows a lower high — which means the 2 signals diverge from one another.

Now…

According to trading textbooks, courses, and etc. they will tell you that when you spot a divergence, it means a reversal is about to occur.

But that couldn’t be further from the truth.

Here’s an example:

stochastic indicator

As you can see, there’s a divergence but the market didn’t reverse.

In fact, it continued to head lower for quite a while.

Now at this point…

You’ve learned the 2 biggest mistakes traders make when using Stochastic and how to avoid it.

Now you’re probably wondering:

“So, what is the correct way to use the Stochastic indicator?”

Well, that’s what I will share in the next section.

Read on…

How to use the Stochastic indicator and “predict” market turning points

If you haven’t realized by now…

The reason why traders fail with Stochastic is because…

You don’t use it in the context of the market.

You’re probably thinking:

“What does it mean?”

Simple.

Trade with the trend — and not against it.

If you look at the earlier examples, most of the common mistakes can be avoided if you’re not trading against the trend.

Make sense?

Great!

Then let’s see how you can adopt this principle and use Stochastic to “predict” market turning points.

Here’s how…

  1. If the price is above 200-period moving average (MA), then look for long setups when Stochastic is oversold
  2. If the price is below 200-period moving average (MA), then look for short setups when Stochastic is overbought

Here’s an example:

Now…

This doesn’t mean you “blindly” go short when Stochastic is overbought.

But it can help you anticipate where the pullback might end, so you can better time your entry and trade with the trend.

Can you see how a simple tweak makes a BIG difference?

Great!

Moving on…

How to use the Stochastic indicator and filter for high probability trading setups

I’m not sure about you.

But whenever I put on a trade, I want to know where I am in the “big picture”.

Why?

Because if you want to find high probability trades, then you want to be trading with the higher timeframe trend — and not against it.

So how do you do it?

Well, you can use the Stochastic indicator to filter your trades.

Here’s how…

Let’s say you want to go long on the 1-hour timeframe.

But before you do so, check the daily timeframe and see where you are in the “big picture”.

You want to make sure the daily timeframe is not in a downtrend with Stochastic overbought.

Because that’s where the market is likely to head lower — and you don’t want to be long.

An example:

Most of you might want to go long based on the chart below…

But…

If you look at the higher timeframe, you’ll realize something is not right.

The higher timeframe is in a downtrend and Stochastic is at overbought level.

So chances are, the market is likely to continue trading lower, and you don’t want to be long.

Here’s what you should do instead:

If the Daily timeframe is in a downtrend with stochastic overbought…

You’ll look for trading setup on the lower timeframe – to go short.

Your entry trigger can be a bearish breakdown from Support on the 1-Hour timeframe.

I’ll explain…

USD/CHF on Daily timeframe with Stochastic overbought:

USD/CHF on 1-Hour timeframe breaking down from support:

Can you see how it works?

Great!

How to use the Stochastic indicator to better time your entries

Now unlike chart or candlestick patterns where the entry can be subjective, the Stochastic indicator doesn’t give you that problem.

That’s because there’s no discretion for the entry.

It’s either YES you enter, or NO you stay out.

So if you’re the type of trader that is always unsure whether you should pull the trigger, then this entry technique is for you…

Here’s how…

  • If you have a long bias, then go long when the Stochastic line crosses above 20
  • If you have a short bias, then go short when the Stochastic line crosses below 80

Here’s an example:

Now, what does this means?

Recall:

The Stochastic indicator measures momentum.

So, when you see the Stochastic crossing above 20, it’s telling you bullish momentum is stepping in (and vice versa).

And one important thing:

Don’t mistake this as a trading strategy because it’s not.

Rather, it’s an entry trigger to get you into a trade.

A BIG difference.

Why you don’t need to use Stochastic indicator in a range market

Now:

If you search the internet, books, courses, and etc, they will tell you the best time to use the Stochastic indicator is in a range market.

Why?

Because you can wait for the price to be overbought before shorting (and vice versa)

An example:

And from the looks of it, it seems that Stochastic indicator can pinpoint the tops/bottoms of a range with deadly accuracy.

But here’s the thing:

Do you REALLY need a stochastic indicator to do so?

Nah.

Because all you need to do is…

Buy Support.

Short Resistance.

And voila! You get the same result.

Here’s what I mean:

As you can see… you’ve accomplished the same thing as what Stochastic did — but with less clutter on your charts.

Does it make sense?

Awesome!

Frequently asked questions

#1: How can I use Stochastic Indicator to tell me if the market is in a range?

You don’t need to use the Stochastic Indicator to tell you if the market is in a range or not. Because if you find that the price keeps retesting the highs or lows multiple times, then the market is in a range.

Alternatively, when the market is in a range, you’ll observe that the Stochastic Indicator tends to reverse near the 70 area and the 30 area. For example, if the market is in a range, it tends to find support when the Stochastic value is at 30 and it tends to find resistance when Stochastic value is at 70.

#2: Is there a good way to combine the Stochastic Indicator with other indicators?

Yes, it’s possible. Stochastic Indicator is useful to identify area of value on your chart and to serve as an entry trigger.

The first way to go about it is to combine the Stochastic with a moving average:

  1. Use a moving average to determine the trend
  2. Use the Stochastic to identify the area of value in the trend
  3. Then use candlestick patterns to serve as an entry trigger

Alternatively, you can:

  1. Use a moving average as a trend filter
  2. Use support and resistance as an area of value
  3. Then use Stochastic Indicator as your entry trigger

In this case, Stochastic is acting as an entry trigger. So if the market is in a downtrend and the price is at resistance, you can look to sell when the Stochastic crosses below 70.

Conclusion

So here’s what you’ve learned today:

  • The stochastic is an indicator that measures momentum
  • Don’t go short just because Stochastic is overbought because it can remain overbought for a long time
  • Spotting a divergence doesn’t mean the market will reverse. It fails more often than not in a trending market
  • In a downtrend, overbought level on Stochastic can help you time when the pullback might end (and vice versa in an uptrend)
  • The Stochastic can serve as an entry trigger to go long when it rises above 20 (and short when it cross below 80)

Now here’s my question for you…

How do you use the Stochastic indicator?

Leave a comment below and share your thoughts with me.

  • Rayner you are an Iumination to your generation and beyond. i have struggled to understand this stochastic concept for a while now. but today after reading and watching this material, am good. and have started making profit instantly. more wisdom to you.

  • Rayner- you are god-sent. It could not be explained any simpler. Sharing this and many previous videos only shows the caring side of you. Thanks.

  • I printed out this article and brought on my work. I want to master in stock trading even if i have a full-time job here in Philippines. I keep reading on it even my co workers laugh at me.thank you rayner

  • I’m new to this so I’m still researching about these indicators. But I think it would be best to use it together with other indicators like candle stick patterns, moving averages, support and resistance, and the like. Is that a good way to use stochastics? Thanks a lot sir Rayner.

  • Hi Rayner, Thank you very much. this is very helpful for me or us newbie in trading fx or stock. You are inspiration just like your fried from the Philippines JC Bisnar. Im from philippines and big fan and a follower of you in investa and fb. Again, thank you very much.

  • Thanks Rayner for sharing your professionalism with us !

    When checking time frame, what I notice is that, H1 is trending downwards and EMA is above which is what we are looking for, but on D1 is trending upwards and EMA is bellow, which confuses potential pull-back entry.
    Which time frame should we follow, H1 or D1 ?
    Also, do we need to take into consideration W1 an MN time frames ?

    Many Thanks for your help !

    HAPPY NEW YEAR 1

    • To determine what best time frame to use on Monday create EMA 133 or SMA 200 from your chart I prefer Exponential Moving Average 133 by Friday compare you EMA 133 from 15min to 4H chart you will notice the market support and resistance were respecting more the 30Min & 1H chart.

      Best time frame to trade 1H and your pull back 30Min. There 4H and D1 serve as mirrors for a bigger picture

  • An excellent summary of the stochastic indicator however I do use the two lines it has definitely shown me that when it’s over 85% and they sometimes touches a hundred that is a rally

  • Hi Rayener,

    You nailed it!!!!

    But I have a question. When you were talking about using Stochastic as entry trigger, you mentioned we can go long when Stochastic crosses above 20 and short when Stochastic crosses below 80. Is it irrespective of trend in higher timer frame? In other words, is it about following short term trends (or pullbacks)?

  • During oversold or overbought, go back to SnR rules and candle anatomy to see it is reversal pin bar or engulfing candle or insider bar.

  • wow! Rayner i have learnt that the stochastic is an indicator that is used to measure momentum. i shouldn’t go long or short simply because the stoch is over bought or over sold! i have learnt that i can use the stoch to better time my entries that is when am using the stoch settings 20,1,1,,, with good trade setups! thanks man

  • Thank you for the information shared, I learned a lot and now I can use stochastic with confidance. Keep it up

  • Nice one Rayner. Thank you. I have one question. If you check one the 1 hour timeframe and it’s an uptrend but in the daily timeframe it’s a downtrend, would you advice to base the trade upon the daily timeframe or just ignore the pair? PS: you’re an intraday trader.

    • You can trade the long side on the 1-hour timeframe but know that you’re trading against the higher timeframe trend, so you exit should be more conservative and don’t overstay your welcome.

  • Thank you for this lesson, i learnt new thing today about the use of Stochastic indicator.it was really a good lesson.thanks.[i use 14,3,3, before but i need more clarification please.]

  • Rayner, I really like how you explained support resistance levels using stochastic indicator, also knowing what the lower time frame is doing stochastic wise what higher the time frame.
    Great job
    God Bless

  • My entries are based on stochastics.
    I use 100MA, if it points up, and stochastics is moving out of oversold, i go long. and vice versa for short entries.
    But my exits has nothing to do with stochastics.

  • Read this but can’t stop thinking about the simplicity of such huge information given out for free when others would have sold this stuff maybe for a 100dollar. I am so humbled by your desire to help others succeed inspire of your busy schedule. You amazed me by the way you keep rewriting the wrongs we have read about trading from some of these so-called trading books with simplicity. No wonder simple trading concept are more profitable. Thank you for your time, thank your for all your articles, thank you for your videos. Always know that there is someone’s life in the deep part of Africa you are changing for the better as the days passes by. God bless greatly. Keep flourishing, my friend. Once again, thank you!!!

  • HEY Rayner, i am trading using FXCM trading station, noticed that you are using trading view with stochastic parameter 20,1,1, what is the parameter setting in FXCM ? it looks diffrent at FXCM trading station

  • Thank you. Very glad to learn that short stock below 200 MA & Stochastic oversold then. Sir, will you please describe RSI and ADX in such a simple way ?

  • I’ve been using stochastic indicator wrong thoo its been giving me good results I guess it’s I’ve just been lucky with my trading, Thanks Rayner for educating us on this indicators your doing a nice work God will reward you abundantly.
    Regards

  • I buy when the stochastic cross above 20 level and sell when the stochastic cross below 80 level. And if I’m buying 1h time frame I must first check if daily time frame is above 200ma and stochastic is oversold and if it’s below 200ma I must check D1 if it is below 200ma and stochastic is overbought.

  • The chart you used in this article of Euro FX/British Pound is same as was shown in “The NO BS guide to Swing Trading”.Isnt it?

    It might not be a good idea to show the same chart every where to prove your point and make your life easier..

    Please dont get me wrong, I too want to help traders only…and I feel constructive criticism always helps…Isnt it?

  • I use my Stochastics with 20,9,2 setting. I used to use it with 5,3,2 setting but it’s a bit too noisy for my liking. I started using the 20 because of you. Pretty good entry and sell signal when there’s a crossover of the 20 and 9. Can’t rely on just that though. You have to wait for confirmation because it can turn on the dime! The idea is the same though. Thanks for all that you do! Over 2 years in the market and you’ve turned my trading experience around!

  • You said friend short when it is below 80 , but many times it reverse from there and go again in overbought area, it can happen 3 4 times

  • Hey Rayner! Thanks for your tutorial! It’s great!
    Right after I read your tutorial here, I come up with something! Using your Osci set up and technique, I can combine it with breakout system and ride the massive trend after that.
    Your YT Channel is also inspired me to create my own channel and share my experiment about Osci breakout. First start is good, because I made 800 pips floating plus, and CUT the LOSSES with minimal amount of risk.
    You can check my vid here if you don’t mind
    https://www.youtube.com/watch?v=8I28_5_2zwU

    Thanks. So much love from Japan.

  • Go long when it crosses above 20 and short when it crosses below 80. But in the section where we can use MA with Stoch, when in downtrend, and price at resistance level, go short when the stoch is below 70. Then why not in 80 level?

  • One of the best explanation that I could have received on the correct way to use Stochastic. Indicator. All the clutter in my mind is gone. Thanks for piecing the article in such simple language !!!!!

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