Stochastics: A Momentum Trading Indicator

The Stochastic Oscillator is a momentum trading indicator that uses the velocity of a financial instrument’s fluctuation in price to provide buy/sell signals. Stochastics usually move before price changes and divergences in Stochastics can be used to predict financial instrument pricing reversals.

Benchmarks used to calculate Stochastics are:

  • Most recent closing price
  • Lowest price in the last X amount of trading periods
  • Highest price in the last X amount of trading periods
  • 3 day simple moving average

Overbought and Oversold Extremes

The Stochastics Oscillator is often used as a trading indicator for overbought and oversold extreme market conditions. According to general theory of Stochastics, the current market cycle trend determines whether a trading session’s closing price will be closer to the day’s high (uptrend) or low (downtrend).

Below is a chart showing Stochastics being used on a chart of the S&P 500:

You can see above on the chart where a buy signal threshold is made crossing the purple line (20) and where a sell signal is made crossing the yellow line (80).

Stochastics & Relative Strength Index (RSI)

Relative Strength Index (RSI) is another commonly used price momentum indicator that helps traders identify market trends. Both technical indicators use pre-established thresholds to determine buy/sell levels.

Some traders choose to use both trading indicators in tandem to receive a broader technical reading:

  • Relative Strength Index (RSI) – A reading on the 0 to 100 scale below 30 or exceeding 70 are buy/sell signal levels
  • Stochastics – A reading below 20 or exceeding 80 are buy/sell signal levels

Are you interested in using Stochastics or the RSI in a trade simulator?

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