How to trade crypto with the stochastic indicator

Trading
October 10, 2019

The stochastic oscillator is one of the most commonly used technical indicators for crypto trading. It comes from the family of momentum indicators as it is bounded by a 0-100 range of values. As is the case with other technical indicators, Stochastic has its advantages and drawbacks, and it’s best used in combination with other indicators.   

Structure of the Stochastic oscillator

Developed in the late 1950s by George Lane, the Stochastic oscillator calculates the location of the closing price of a particular asset compared to the high and low range of the price, of the same asset, over a period of time.

The most common Stochastic setting is 14 - 3 - 3. A number of charting tools, including Sparkdex, have this setting as a built-in feature for Stochastic. This setting is used for the full Stochastic technical indicator, while 14 - 3 is used for either fast or slow Stochastic down. 

Below, you will find formula explaining how Stochastic is calculated.


Stochastic Formula (Source: Investopedia)
Stochastic Formula (Source: Investopedia)


In essence, Stochastic is used to gauge the current market sentiment. If the market is in a bullish state, Stochastic readings will be closer to 100 than 0, and vice versa. It is designed in such a way that it is always between 0 and 100. Contrary to some other indicators, Stochastic can’t display negative, or readings above 100.

Conventionally, most crypto traders use 80 and 20 as threshold values. Any reading above 80 signals that the market is trading in overbought conditions, while readings below 20 refer to an oversold market condition. When Stochastic hits extreme readings i.e. above 80 or lower than 20, it only signals that the market is overbought or oversold. However, that doesn’t automatically mean that a reversal is in the cards.

Common mistakes made by crypto traders

Exactly here, many crypto traders make mistakes. In the chart below, we see the Stochastic signalling that Bitcoin has entered into the overbought territory with a reading higher than 80. As a trader you may use this signal to short Bitcoin, since a reversal may be happening soon. However, the reading of 82, for instance, can always become 92. The same applies for the oversold conditions if Bitcoin reads below 20. 

Stochastic overbought sample (Source: TradingView)
Stochastic overbought sample (Source: TradingView)


Furthermore, since we are already in an extreme territory, the Stochastic travels slower from 82 to 92 than from, for instance, 52 to 62. In this particular case, the price moved from $10,250 to $10,450, while Stochastic had been located in the overbought territory the entire time. 

This is why you should always use Stochastic in combination with other technical indicators. 

Use Stochastic to Generate Trading Signals

In general, there are two popular trading techniques to generate trading signals by using the Stochastic oscillator.

One of the most popular ways to interpret Stochastic is to look for divergence, which happens when there is a difference in signals between the Stochastic oscillator and the current trending price action. In the example below, the price action creates a lower low, however, the Stochastic oscillator moves upwards as it prints a higher low at exactly the same time. This is called bullish divergence as it issues a signal to initiate longs. 


Stochastic divergence sample (Source: TradingView)
Stochastic divergence sample (Source: TradingView)


Once the price action has created a lower low, the price moves back higher, confirming the bullish signal issued by Stochastic indicator. The bearish divergence works the other way around - consider shorting the asset if the price makes a higher high, but Stochastic makes lower high.

The second trading technique is based on mixing signals from the Stochastic oscillator and other technical indicators. Crypto traders adopting this trading style argue that one should always consult Stochastic readings when the buy and sell signals are issued by one or more of other technical indicators. 

Stochastic confluence (Source: TradingView)
Stochastic confluence (Source: TradingView)


An example of this trading technique is shown in the Bitcoin price chart above. Based on other technical indicators, in this case the Fibonacci retracement and the moving average, we have identified a level of interest to short BTC/USD as the price touched the confluence of resistance levels - the key 61.8% Fibonacci retracement zone and 200 MA on a daily chart. 

In addition, the Stochastic is well above the reading of 90, which signals Bitcoin is overbought on a daily basis. Since all three technical indicators seem to suggest that a reversal may be happening soon, a short position is initiated given the strength of the resistance block.

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