Stochastic Oscillator Explained: Everything A Crypto Trading Beginner Should Know

An interesting fact about oscillators as technical indicators is that we have not yet fully uncovered their complete potential. One of the most prominent oscillators in this regard is the Stochastic Oscillator (STOCH). This indicator has layers of complexity waiting to be explored, making it a valuable tool for technical analysis. Becoming proficient in using this indicator can give you a significant advantage over others in the field, providing you with a strong skill. Let’s learn the Stochastic Oscillator to acquire one of the most valuable analytical skills you can possess to excel in this sector.

1. Stochastic Oscillator: What You Should Know

Similar to RSI, the Stochastic Oscillator is a momentum indicator. Developed by Dr. George Lane in the 1950s, this indicator shows a cryptocurrency’s closing price relative to its high and low prices over a selected ‘LookBack’ period, typically 14 days.

It is helpful for deciding the right time to enter or exit the market, as it can analyse situations where crypots are either overbought or oversold. 

A Stochastic Oscillator plots two lines: %K and %D. The line %D closely follows the line %K. And, they often intercept. 

Let’s try to learn the concepts behind these two plot lines in a simple way.   

1.1. What Does %K Represent in STOCH

%K shows if the current price of a cryptocurrency is closer to recent highs or lows over a specific period.  

1.2. What Does %D Represent in STOCH 

%D involves taking the average of %K values over a specified period, often 3 periods. It reflects a more smooth representation of price movement.

1.2.1. Importance of Smoothing in Stochastic Oscillator 

Smoothing is generally used to reduce price fluctuations for better trend analysis. Similar to how we use %D for a smoother %K, we can make %K even more smoother. If we choose a 14-period and set %K smoothing to 3, it takes an average of the %K value of the last three consecutive 14-period time frames. The resulting %D, based on this smoothed %K, is a more refined and smoother indicator.

Your understanding about the concepts can be expanded if you have good clarity about the calculations created using these concepts.   

2. Learn How to Calculate STOCH

If you have understood the concept part, you may not find any difficulty in understanding this calculation section. For %K and %D, we have two different formulas. 

Let’s explore one by one.  

Let’s understand what each of them represents.

C = Current Closing Price 

Ln = Low in The Chosen ‘Lookback’ period 

Hn= High in The Chosen ‘Lookback’ Period 

Time to explore the practical side of this indicator. You can choose TradingView for this purpose. 

3. How to Launch Stochastic Oscillator in TradingView

Applying a Stochastic Oscillator inside a TradingView chart is a simple four-step process.

• Step 1: Sign in to TradingView

Log in to your TradingView account or create one if you don’t have one.

• Step 2: Select a Crypto Chart 

Use the search option to choose a crypto chart. 

• Step 3: Launch Stochastic Indicator  

Click on the ‘Indicators’ button, located in the top bar, search for ‘Stochastic Oscillator’, and select it.

• Step 4: Set inputs 

In the Stochastic settings, adjust ‘%K Length, ‘%K Smoothing,’ and ‘%D Smoothing’ as per your preference.

3.1. Setting Inputs for Stochastic Oscillator: What You Need To Know

Setting the inputs in the Stochastic Oscillator correctly is crucial to make the indicator operate the way you want. To do so, you should have a clear understanding about every element in the input section. Primary, there are three important ones: %K Length, %K Smoothing, and %D Smoothing. 

• %K Length:– It is the number of days considered for %K calculation. A higher number smooths the indicator, while a lower one makes it more responsive. 

• %K Smoothing:- It improves %K’s readability. Through a moving average, it calculates the average of recent ‘%K values. Unlike ‘%D’, it uses ‘%K’ values from the chosen time period and the corresponding ‘%K’ values from the preceding time periods of the same length. 

• %D Smoothing:- %D smooths %K further. It is calculated as a moving average of %K. 

3.1.1. What Is the Best Setting For A Stochastic Oscillator 

The best Stochastic Oscillator settings depend solely on the asset and trading strategy. The default values are 14 for %K Length, 1 for %K Smoothing, and 3 for %D Smoothing. You can experiment with these input elements to find the right fit.  

For the learning purpose, now, you can open the Bitcoin/TetherUS daily chart. Launch the indicator, and keep the default input settings as it is. 

Once you press the ok button, you would see an oscillator, ranging between 0 to 100, with two lines, %K and %D. 

4. Ways to Use Stochastic Oscillator in Crypto Trading 

Primarily, Stochastic Oscillator serve three key purposes 

• Overbought/Oversold Signals:- When Stochastic Oscillator moves into the overbought region, it indicates a market top. Conversely, entering the oversold region suggests a potential market bottom. 

• Crossovers as Signals:- The %K line crossing below the %D line is a selling signal, indicating a weakening momentum. Conversely, the %K line crossing above the %D line can be a buy signal, signalling potential strength.

• Divergence:- Divergence occurs when the Stochastic Oscillator disagrees with price trends. For instance, if prices make higher highs while the oscillator doesn’t, it can signal a potential trend reversal.  

Endnote 

In conclusion, Stochastic Oscillator is a highly useful technical indicator used in cryptocurrency trading. It helps traders identify overbought and oversold conditions, provides signals through crossovers of %K and %D lines, and detects potential trend reversals through divergence. Understanding its calculations and settings can give you a valuable edge in analysing cryptocurrency markets. Keep one thing in mind that the best settings for Stochastic Oscillator may vary depending on the asset and trading strategy. What this highlights is the importance of experimentation in maximising the effectiveness of this indicator. 

Well Done! You have now completed the Lesson.

Complete the Quiz and Get Certified! All The Best!

Enroll Quiz