What is stochastic oscillator: gauging momentum with %K and %D

As a highly volatile digital asset that's available for trading on a 24/7 basis, the crypto market can be a difficult beast to tame for even the most experienced of crypto traders. That's where momentum-based trading indicators come in handy. The stochastic oscillator is one example of such a powerful technical analysis (TA) tool that focuses on momentum — a fancy way of saying how quickly a price is moving. By understanding momentum, you can gain valuable clues about potential trend reversals and identify overbought or oversold conditions.

TL;DR

• The stochastic oscillator helps you identify momentum shifts and areas where prices might be overbought or oversold, hinting at potential trend reversals in the crypto market.

• While beginner-friendly and highly customizable, the stochastic oscillator may sometimes display false signals and be hard to rely on during volatile times because it's a lagging indicator.

• To strengthen the validity of the stochastic oscillator's signals, it's crucial to combine it with other technical indicators like the relative strength index or moving average convergence divergence, and consider how the price is behaving around support and resistance levels.

• Stochastic oscillator divergences can be a good way to discover potential trend reversals.

• Compared to the stochastic oscillator, the KDJ indicator is sometimes preferred because it captures the rate of change in momentum.

What is the stochastic oscillator?

The stochastic oscillator is a popular indicator that measures the relationship between a security's closing price and its price range over a specific period. It helps visualize momentum by displaying a value between 0 and 100 that highlights the asset's existing status and whether it's overbought or oversold.

Stochastic oscillator strengths

As a popular choice among competing momentum indicators, the stochastic oscillator stands out for the following reasons.

• Simplicity and ease of use: The stochastic oscillator boasts a user-friendly interface with only two primary lines (%K and %D) to interpret. This makes it easier for beginners to grasp its functionality compared to more complex indicators.

• Clear overbought and oversold signals: The indicator displays values within a well-defined range (0-100), with clear zones for overbought and oversold conditions. This straightforward interpretation allows for quick identification of potential buying and selling opportunities.

• Responsive to price changes: The stochastic oscillator is known for its relatively quick response to price fluctuations. This allows traders to identify potential trend shifts and react accordingly in a fast-paced market like cryptocurrency.

• Widely customizable: The stochastic oscillator offers flexibility in terms of its parameters. Users can adjust the timeframe to better suit their trading style and the specific asset they're analyzing.

Stochastic oscillator limitations

While the stochastic oscillator is a valuable tool, it's crucial to understand its limitations.

• False signals: Overbought and oversold readings sometimes don't guarantee price reversals. This is because the crypto market can often stay overbought or oversold for extended periods and can possibly lead to missed opportunities or even false entries if solely relying on the signals of a single trading indicator.

• Lagging indicator: As mentioned earlier, the stochastic oscillator is based on moving averages, making it a lagging indicator. It reacts to past price movements rather than predicting future trends. This inherent lag can be problematic in fast-paced markets where prices can reverse quickly.

• No consideration of volume: By solely focusing on price movements, the stochastic oscillator doesn't take into account trading volume, which can be a crucial indicator of market strength behind a price move. High volume alongside overbought/oversold readings can indicate a stronger signal for a potential reversal, while low volume readings might suggest the market lacks conviction behind the price movement.

The stochastic oscillator formula

%K = [ (C−L14) / (H14−L14) ] × 100

The stochastic oscillator uses a formula to translate price movements into a clear 0-100 value range, helping traders identify potential overbought and oversold conditions. This formula involves calculating the difference between the current closing price (C) and the lowest low within a specific time period (L14). This difference is then divided by the overall price range for that same period, determined by the difference between the highest high and the lowest low (H14 - L14). Finally, the result is multiplied by 100 to express it as a percentage value within the 0-100 range. This value is known as %K and represents short-term momentum.

A smoothing process is then applied using a moving average to create the %D line, which provides a clearer picture of the overall trend and helps filter out short-term price fluctuations. By analyzing the position of these lines and their interaction within the 0-100 range, traders can gain valuable insights into potential buying and selling opportunities in the cryptocurrency market.

How does the stochastic oscillator work?

The magic behind the stochastic oscillator lies in two lines: %K and %D.

• %K: This line represents the latest closing price in relation to the price range over a defined period. With the default settings of the stochastic oscillator, the period should be 14 days. This reflects the short-term momentum of what the asset is experiencing.

• %D: This line acts as a moving average of %K, smoothing out any sharp fluctuations and providing a clearer picture of the overall trend.

These two lines combine on the chart, revealing valuable insights into the market's sentiment. They work in tandem to ultimately signal if an asset's price is overbought or oversold based on the following conditions.

• Overbought: Stochastic oscillator values above 80 suggest the asset might be overvalued and ripe for a potential price correction.

• Oversold: Stochastic oscillator values below 20 hint that the asset might be undervalued and could be due for a rebound.

Interpreting the stochastic oscillator's signals

Now that you understand the basics, let's delve deeper into understanding the signals the stochastic oscillator throws your way.

Overbought and oversold territories

As mentioned earlier, the stochastic oscillator helps identify potential overbought and oversold conditions.

• A sign of euphoria during overbought conditions: When the stochastic oscillator ventures into overbought territory, it suggests that the price might have risen too quickly and could be due for a correction. This doesn't guarantee a price drop, but it raises a cautionary flag.

• Signs of fear during oversold conditions: Conversely, oversold readings might indicate a potential buying opportunity. The asset might be undervalued and could be poised for a rebound. However, remember that oversold conditions can persist for extended periods, especially in strong downtrends where panic-induced sell-offs tend to happen.

While many crypto traders rely on the stochastic oscillator, it's crucial to keep in mind that these are just general guidelines. Traders shouldn't rely solely on overbought and oversold signals to make overall trading decisions. Rather, the stochastic oscillator should be considered pieces of the wider puzzle, alongside other technical indicators and market factors.

Crossovers of the %K and %D lines

The %K and %D lines within the stochastic oscillator aren't just static indicators. They interact with each other, generating potential trading signals through their crossovers.

When the faster %K line crosses above the slower %D line and both lines are trending upwards towards the midline, it can be interpreted as a bullish signal. This suggests a potential shift in momentum towards an uptrend, with the price potentially breaking above resistance levels.

On the opposite side, if the %K line dips below the %D line and both lines are trending downwards, it can be seen as a bearish signal. This suggests a weakening uptrend or a potential reversal towards a downtrend, with the price potentially breaking below support levels.

What to do during stochastic oscillator divergences

Sometimes, the price action of an asset and the stochastic oscillator might be sending conflicting signals. This is called a divergence, and it can be a powerful indicator of a potential trend reversal. However, before diving headfirst into a trade, here are some crucial steps to take.

1. Identifying the divergence type

Bullish divergence: When the price makes a new low but the stochastic oscillator forms a higher low, it suggests a weakening bearish trend. This could be a sign of a potential reversal towards an uptrend.

Bearish divergence: Conversely, if the price makes a new high but the stochastic oscillator forms a lower high, it suggests a weakening bullish trend. This could be a warning sign of a potential reversal towards a downtrend.

2. Seeking confirmation

Divergences are valuable clues, but they're not guarantees. To strengthen your conviction of this potential trade, look for confirmation from other technical indicators and price action. Indicators wise, you could consider signals from momentum-based indicators like the relative strength index (RSI) or moving average convergence divergence (MACD) that align with the potential trend reversal suggested by the divergence.

As for price action, crypto traders can observe how the price reacts around the support and resistance levels after the divergence forms. A strong bounce off support after a bullish divergence or a breakdown through resistance following a bearish divergence can add weight to the reversal possibility.

3. Considering the market context

Now that you've identified the type of divergence and have sought confirmation, one last step is to consider the existing market sentiment. As TA may sometimes cause an overreliance on technical indicators, it's important to remember to not trade in isolation. Look at the broader market sentiment, news events, and overall price trends. These factors can ultimately influence the validity of the divergence signal.

Stochastic oscillator vs. KDJ indicator: understanding the similarities and differences

You might have encountered another indicator called the KDJ while exploring the ins and outs of the stochastic oscillator. While they share some similarities, there's a key distinction between them.

Similarities

• Both the stochastic oscillator and the KDJ are momentum indicators that analyze the relationship between a security's closing price and its price range over a defined period.

• They both display values between 0 and 100, with interpretations for overbought and oversold conditions mirroring each other (above 80 for overbought, below 20 for oversold).

• Both indicators use %K and %D lines to represent short-term and smoothed momentum, respectively.

Differences

• The KDJ includes a third line called the J line. This line reflects the difference between the %K and %D values, aiming to capture the rate of change in the momentum.

In essence, the KDJ offers an additional layer of detail compared to the stochastic oscillator. However, while some see the J line as a 'supercharged' feature, it can also introduce more noise and potentially generate false signals. These false signals can be mitigated by using the J line in conjunction with other technical indicators, or by focusing on stronger deviations in the J line for confirmation.

Overall, the choice between the stochastic oscillator and the KDJ depends on your trading style and risk tolerance. For beginners, the stochastic oscillator might be a good starting point due to its simplicity and ease of interpretation. As for experienced traders, the KDJ can provide more granular insights with the J line, but it requires a deeper understanding and the ability to filter out potential false signals.

Stochastic oscillator trading strategy example

Now that you're equipped with the knowledge to interpret the stochastic oscillator's signals, let's explore a basic trading example. We'll be taking a look at a potential ETH long trade in early July 2024 and configuring the stochastic oscillator to display ETH's momentum over the past 14 periods.

Applying the stochastic oscillator to a potential ETH long trade in early July 2024

Chart analysis

Based on the chart above, the stochastic oscillator lines %K and %D are currently at 10.02 and 25.49 respectively. This puts the stochastic oscillator in oversold territory, given that it's below 20. While risk-averse crypto traders may prefer inaction because it can feel like you're attempting to catch a falling knife given the bearish existing market sentiment, it does present a stochastic oscillator-based trading opportunity to buy the dip given the sudden bearish momentum.

Confirming the current trend

To confirm this potential for a possible price reversal, we can reference the chart above for potential zones of support and resistance. After some candlestick analysis, we're able to see that ETH prices tend to show some form of strength at the $2,800 price range. If ETH prices bounce off $2,800 on this occasion, we may be able to take this as a form of bullish price action as ETH long buyers can hold onto this zone of support despite the bearish selloff across the market.

Entering and planning your potential exit

Based on the available signals garnered from the stochastic oscillator and potential support zone, crypto traders with a bullish inclination may choose to make a long spot entry on ETH. Let's assume you get filled at $2,850. Upon successful entry, you'll now need to plan your exit so you can lock in those gains. In this instance, let's reference the stochastic oscillator indicator to judge when ETH begins to look overbought.

From May 20 to May 30, 2024, we saw stochastic oscillator levels cross into the overbought territory for about 10 trading days before retracing into the neutral territory. Looking ahead, if you're intending to close your long ETH position, crypto traders can reference the stochastic oscillator for any signs of breaching the overbought zone as it can be your cue to exit.

Final words and next steps

With its always-on operation and inherent volatility, the crypto market can feel like a daunting arena even for seasoned traders. This is where TA tools like the stochastic oscillator come into play. It empowers you to gauge momentum, a crucial indicator of potential price trends. By understanding how the stochastic oscillator works and its limitations, you can make informed trading decisions and navigate the ever-changing crypto landscape with more confidence.

Interested in learning more about crypto trading? Read our guide to technical analysis 101 so you can grasp all the basics about TA. And, you can elevate your crypto trading abilities by considering crypto options trading and trying out the options wheel strategy.