Stochastics Are Your Secret Pressure Gauge

Introduction

For every trader, price action analysis is the primary factor that goes into making a trading decision. It is always advisable to combine your price analysis with a reliable technical indicator for additional confirmation. Let’s learn how to combine our typical price analysis with the stochastic oscillator to make accurate trading decisions.     

The stochastic oscillator is a momentum indicator. It shows when the asset is at the overbought or the oversold territory by comparing the price changes over a specified period. This indicator can be used as a support to our price analysis and determine when to enter and exit a position at the most optimal price points. 

Remember, in the markets, the forces of demand and supply determine the price. Therefore, when there are net buyers, the price is bound to go up.  When there are net sellers, the price can be expected to drop. The stochastic oscillator is the perfect indicator to use as a pressure gauge between the buyers and sellers.

Before we talk about our unique way to use the stochastic oscillator as a pressure gauge, let’s explain a little about how this indicator works and how it is traditionally used to support trading decisions.  If you are already familiar with these concepts, skip down to the section on “The Pressure Gauge”.

Components of the Stochastic Oscillator

The stochastic oscillator is a range-bound indicator; which means it has an upper bound of 100 and a lower bound of 0. Traders can adjust these bounds depending on their trading style. For this analysis, we will use the upper bound as 80 and the lower bound as 20.

The indicator itself is made up of two lines. A %k line also called the fast-stochastic line, and a %D line also called the slow stochastic line. The crossover between these two lines can be used to confirm the entry and exit points.

Identifying Overbought & Oversold Market Conditions Using the Stochastic 

Overbought Regions

The stochastic oscillator compares the closing prices of a currency pair with the highest and lowest prices recorded during the selected period. It then ranks the closing price from the range of 0 to 100. 

When the price of an asset goes beyond the upper bound, it means that the asset is overbought. This is a result of persistent buying pressure in the market, which results in the price going higher. Often, when the price reaches the overbought region, it is an indicator that the asset is recording higher highs.

When an asset is overbought, it means that the buying pressure is likely about to dissipate since traders who are in long positions will start taking profits. Therefore, there will be more sellers than buyers in the market, which in turn creates downward pressure on the price. When the price reaches the overbought region, and your price action analysis shows a sell signal as well, we can say that your analysis is supported by the stochastic.

Oversold Regions 

An asset enters the oversold region when the stochastic oscillator crosses below the lower bound of 20. This implies that there is a persistent pressure in the market by the short sellers driving the prices down. Generally when the asset reaches the oversold territory, it implies that the pressure from the sellers has forced it to record lower lows.

In the oversold region, the sellers in the market are likely to be exhausted. Their selling momentum is dissipating as they embark on profit-taking. It is, therefore, more likely that there will be a trend reversal.  Sellers in the market are turning to buyers. When there are net buyers, the price will be pressured upwards. The price reaching the oversold region is an indicator of a potential end to the downtrend.

How The Stochastic Crossover Strategy Shows Trend Reversals?

Note that the stochastic oscillator does not generate ‘buy’ and ‘sell’ signals by itself. Rather it can be used to show regions of a potential trend reversal, which, if supported by price action analysis can be the optimal entry and exit points.

Reversal of a bearish trend

A stochastic crossover occurs when the fast-moving stochastic line intersects with the slow-moving stochastic line.

A downtrend is reversed when the fast-moving stochastic line (%k line) crosses the slow-moving stochastic line (%D line) from below and rises above it. When this happens, it means that there is a buying pressure in the market. This usually results in the market price moving up.

Only open a long position when your price analysis supports an entry.  You would look for the immediate candle after the %k to cross above the %D line is bullish. This is a confirmation that the upward pressure by the buyers is gaining momentum. It also helps you to avoid any fake-out crossovers.

Note that the indication to exit a long trade after a crossover is when the stochastic line reaches the upper bound. In this region, you can expect the price to enter into the overbought territory where the upward momentum potentially reduces.  Once again, use the stochastic to support your price analysis – not the other way around!

Reversal of a bullish trend

The stochastic oscillator will indicate a potential bullish trend reversal when the %k line crosses below the %D line. This shows that sellers in the market are exerting a downward pressure on price.

Price confirmation of a change in direction after this crossover would be shown when the immediate candle after the %k crosses below %D line is a bearish candle. It confirms that the downward pressure by the net sellers is gaining momentum.

When the stochastic reaches the lower bound, it is an indication that the downtrend momentum is expected to slow.

Note that the stochastic oscillator is prone to generating false crossover signals. A crossover might occur but fail to follow through. For this reason, you should always rely on your price analysis first and foremost and use the stochastic oscillator to support your analysis and trading decision.

The Stochastic Oscillator as a Pressure Gauge

Divergence happens when the stochastic oscillator does not reflect the highs and lows reached by the price. When a stochastic divergence occurs, it shows that the momentum of the prevailing trend is getting weaker. Thus, it serves as a pressure gauge between the buyers and sellers in the market. 

A bearish divergence occurs when the price reaches new higher highs, but the stochastic oscillator does not register corresponding new highs. Remember that the stochastic oscillator is a momentum indicator. Therefore, when it fails to register new higher highs along with the price action, it means that the momentum of the uptrend is getting weaker. The pressure gauge is showing us that there may be a change in the market sentiment and switch between buyers to sellers.

A bullish divergence occurs when the price action is registering new lower lows while the stochastic is registering new higher lows. This trend shows that the momentum of the downtrend is beginning to slow down and there is a higher probability for a pressure switch from sellers to buyers.

In other instances, you might observe that there is selling pressure on the stochastic oscillator, but the price action does not show the same momentum. This implies that the buyers are absorbing the selling pressure in the market. It is therefore more likely that the price action will move in an uptrend. Here is an illustration.

Similarly, you may observe that the stochastic oscillator shows a sharp momentum uptrend, but there is minimal uptrend registered by the price action. This shows that sellers are absorbing the uptrend pressure exerted by the buyers in the market. Consequently, we are more likely to see the price to have a breakout to the downside. Here’s an example.

Conclusion 

Now you can use the stochastic oscillator as a pressure gauge to show a potential change in the momentum of a trend. Do not use the stochastic oscillator cannot be used to generate signals by itself. It only serves to support the entry and exit points, as shown in your price action analysis. If your price action analysis shows possible trend reversals, this analysis can be supported by the presence of divergence in the stochastic oscillator.  This analysis is also particularly useful in supporting entries where price is moving out of consolidation and into a new trend.