As you progress in your study of cryptocurrency trading and technical analysis, you’ll come across a variety of different indicators that traders use to inform their decisions. From Fibonacci Retracement to the Relative Strength Index, these tools can be helpful in confirming trends or finding opportunities. Some are more complex than others, but one indicator that you’re likely to encounter relatively early on is the stochastic oscillator.
In this article, we’ll take a look at stochastic oscillators and how they help identify potential opportunities in crypto trading.
How Stochastic Oscillators Work
A stochastic oscillator is a momentum indicator that measures the current price relative to the high-low range over a certain period of time. The assumption behind this indicator is that prices tend to close near the extremes when momentum is high, and close near the median when momentum is low.
The stochastic oscillator was invented by Dr. George Lane in the 1950s, and was popularized by renowned stock trader Larry Williams, who devised his own variant of the indicator in the 1960s. Since then, stochastic oscillators have been used by traders in a variety of different markets, including stocks, commodities, and cryptocurrencies.
The simplest form of a stochastic oscillator is %K, where:
Current price = the most recent price
Lowest low = during a certain period
Highest high = the highest price traded during the same period
%K = the current value of the stochastic indicator
Traders can calculate %K as:
%K = (Current Price – Lowest Low) / (Highest High – Lowest Low) * 100
However, this version can produce spikes that make it difficult to interpret, so a moving average (MA) of %K is often used instead. This is known as %D, and is calculated as:
%D = 3-day SMA (Simple Moving Average) of %K
The stochastic oscillator ranges from 0 to 100, with readings below 20 indicating that the market is oversold and readings above 80 indicating that the market is overbought. However, it’s important to note that these levels are not absolute and should be used as guidelines rather than strict rules.
Using Stochastic Oscillators in Crypto Trading
There are a number of different ways that stochastic oscillators can be used in trading cryptocurrencies. One common strategy is to look for divergences between the indicator and price.
A bearish divergence occurs when the indicator is making new highs while prices are failing to do so, which can be a sign that the uptrend is losing momentum and may soon reverse.
Conversely, a bullish divergence occurs when the indicator is making new lows while prices are failing to do so, which can be a sign that the downtrend is losing momentum and may soon reverse.
Another way to use stochastic oscillators is to look for overbought and oversold levels. As we mentioned earlier, readings above 80 are generally considered to be overbought, while readings below 20 are considered to be oversold.
Always remember that this indicator is just that– an indicator. It’s not a guarantee of price movements. An asset’s price can remain overbought or oversold for extended periods of time, despite what the indicator says. As such, it’s often best to use these tools as part of your overall evaluation.
Calculating the Stochastic Oscillator
There are a few different ways to calculate the stochastic oscillator, but the most common is to use the %K and %D formulas that we outlined earlier. Looking in depth at the equations, you’ll notice that there are four key inputs:
- The current close or price
- The highest high over the chosen period
- The lowest low over the chosen period
- The number of periods being considered
Ideally, you want to use as long of a period as possible to avoid false signals. However, using too long of a period will make the indicator less responsive to changes in momentum. As such, many traders use a 14-period stochastic oscillator.
Crypto Trading with Stochastic Oscillators
Stochastic oscillators can be a helpful tool for traders looking to find opportunities in the cryptocurrency market. While they are not perfect, they can be used to identify potential divergences and overbought/oversold levels.
Remember to always use stochastic oscillators in conjunction with other technical indicators and market analysis techniques to get the most accurate picture of the market. And as always, practice risk management to protect your capital.
FTX is a great exchange to begin trading with stochastic oscillators and a wide range of other indicators.
To add the stochastic oscillator to your trading interface, all it takes is two simple steps:
1. From the trading interface, select “Indicators” at the top of the price graph
2. Look up “stochastic” to find the stochastic oscillator indicator, and select “Stochastic.”
That’s it! Your trading interface should now look like this with the stochastic oscillator included:
Additionally, trading on FTX helps to support the exchange’s mission to promote effective altruism.
With each trade, a percentage of the trading fees are contributed to investments in humanitarian-focused projects. So far, nearly $8 million has been contributed as of September 2022. Sign up for an FTX account today or consider joining FTT DAO, a like-minded community of FTX fans fostering effective altruism throughout the globe.