Stochastic Trading Strategies: (Video, Backtest, Indicator & Oscillator)
The stochastic indicator is a standard indicator in any trading platform, but we rarely see it published or used in any Stochastic trading strategies. Compared to the RSI, stochastics seems much less popular. Is that because it’s less useful, or is this a hidden gem?
The stochastic indicator does work in a stochastic trading strategy. It performs quite well as a mean-reversion tool for stock indices.
In this article, we explain what the stochastic indicator is, how it performs, show some stochastic trading strategies, and how stochastic compares to the more famous Relative Strength Indicator. We make a trading strategy based on the stochastic indicator.
What is the stochastic indicator?
A stochastic trading indicator is a technical analysis tool used to identify overbought and oversold conditions in the market. It compares a security’s closing price to its price range over a certain period of time and is typically expressed as a number between 0 and 100.
It’s one of the most popular indicators, and it’s also quite useful. For a comparison, please see our ranking of the best oscillating trading indicators.
The stochastic indicator tracks the relationship of the closing prices in relation to the highs and lows over a defined number of days and smooths the result by using an average. Stochastics is an indicator and oscillator, presumably invented by George Lane as early as the 1950s George Lane referred to stochastics as a momentum indicator.
Further down in the article you find the calculation and Amibroker code which makes it more apparent what stochastics measure. Stochastics is a bit similar to the previous indicator we wrote about, the Williams %R:
The Williams %R is a pretty easy indicator to calculate and understand, while stochastics is slightly more complex.
As a result of the formula, stochastics fluctuates between 0 to 100. Zero or low readings indicate an oversold condition, while 100 or a high reading means an overbought condition. Because of this, stochastics is mainly used as a mean-reversion tool.
What does the stochastic indicator measure?
The stochastics indicator measures the recent strength of the stock (or whatever you are trading) and how it trades compared to the last x days. It doesn’t measure the velocity of the movement but how it fares today compared to the lookback period’s high and low reading