Stochastics : an easy-to-use indicator

The stochastic oscillator shows the rate of change of the closing price of an asset over a given period. By comparing it to the highest and lowest range of the period, it reveals market trends and whether the asset is overbought or oversold. 

This indicator is easy to use on your trading station and is a valuable tool to help you decide whether to buy or sell.   

Definition and usefulness of stochastics

Definition of the stochastic indicator

Stochastics is a stock market indicator commonly used by traders and analysts in Forex and cryptocurrencies. This indicator shows, for a given period of time, the closing price level compared to previous closings, i.e. the price difference recorded over a given period. 

In short, the stochastic indicator shows the rate of change of the closing price over the period.

Usefulness of the stochastic indicator 

By following the evolution of the closing price, the stochastic oscillator enables the detection of highs and lows of cycles in order to :

  • identify a stock market trend 
  • anticipate a slowdown in the trend
  • position yourself to buy or sell

How to use stochastic

Stochastics in a chart

The stochastic indicator is called %K. 

It is expressed as a percentage on a graph : 

  • on the x-axis : the time (the predefined period)
  • on the ordinate : the stochastic indicator (%K)

Formula for calculating the stochastic indicator 

The stochastic indicator of a stock is calculated automatically on your trading station.  % K = ((Closing price at time T - Lowest range in period) / (Highest range in period - Lowest range in period)) *100

Using the stochastic oscillator to anticipate a weakening trend

The stochastic indicator is more precisely an oscillator: it is analyzed with regard to two extremes, namely the lowest closing price and the highest closing price recorded over a period:

  • If the stochastic indicator is located between 0 and 20% of the lowest closing price of the period, the asset is considered oversold (some traders opt for 25%).
  • If the stochastic indicator is located between 80% and 100% of the highest closing price of the period, the asset is considered to be overbought (some traders opt for 75%).

The extreme zone (overbought or oversold) points to a loss of momentum with : 

  • a buy signal when the stochastic leaves the oversold zone (between 0 and 20%)
  • a sell signal when the stochastic leaves the overbought zone (between 80 and 100%)

The indicator may remain stuck in an extreme zone, showing trend inertia.   

Use slow stochastics for better readability

Slowing down the movement of the indicator on the chart enables you to obtain a slow stochastic oscillator, i.e. a smoothed curve (elimination of fluctuations in the moving average). This approach enables you to clearly visualize the  up or down trend of the closing price. The slow stochastic oscillator is referred to as %D.

Please note :

  • %K is the fast stochastic
  • %D is the slow stochastic (smoothed curve)

How to configure the stochastic oscillator

The Stochastic Oscillator is easily set up on most trading stations and can be found among the secondary indicators.

You need to configure :

  • the reference period
  • low and high thresholds
  • the choice of the visualization of the %K and/or %D curve with a smoothing level (the smoothing level 100 of the %K curve corresponds to the smoothing level 0 of the %D curve)

On the chart, the thresholds are highlighted by lines, enabling you to see at a glance the positioning of the stochastic indicator throughout the period in relation to the two selected extremes. This will show you if the trend is oversold, overbought or in the neutral zone. 

In conclusion, the stochastic indicator analyzed in the context of closing price extremes allows to visualise at a glance the trend of the stock with its potential loss of momentum. Easily configurable on trading stations, it is an excellent decision support tool.  


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The history of the stochastic indicator

The stochastic indicator was modeled by trader and technical analyst George Lane in the late 1950s.

Warning : Do not confuse this indicator with stochastics used in mathematics to represent the distribution of chance, which is the opposite of what traders expect !