You may have heard of a lagging or leading indicator before. Maybe your friends have tossed around terms like bullish or bearish divergences, oversold or overbought conditions and what signals you should use to enter or exit the market.
While there are many tools that can assist with this, one often overlooked indicator is called the stochastic oscillator.
Nothing unique to the world of blockchain, the stochastic is a momentum indicator that compares the closing price of the asset with its high-low range over a certain period of time, it's a handy tool. Even better, it works no matter the volatility, even in the fast-moving market for cryptocurrencies.
First, the particulars require a bit of math:
Slow %K= 100 [Sum of the (C - L14) for the %K Slowing Period / Sum of the (H14 – L14) for the %K Slowing Period]
Slow %D = SMA of Slow %K
- C = Latest Close
- L14 = Lowest low for the last 14 periods
- H14 = Highest high for the same 14 periods
- %K Slowing Period = 3.
Fortunately, crypto traders need not worry about the calculation part, as the trading platforms and chart softwares process the complex formula and produce a stochastic oscillator, as seen in the chart below.
All you need to know is how to use the oscillator to maximize your efforts.
Reading the Stochastic Oscillator
To start with, the indicator can range from 0 to 100. The area above 80 represents overbought conditions, and the area below 20 indicates oversold conditions.
So, price rallies usually stall after the stochastic reaches an overbought zone. On the other hand, stochastics reporting oversold conditions are widely considered a sign the bears have reached a point of exhaustion.
Further, trend reversal signal occurs when the %K line and the %D line cross in the overbought (above 80.00) or oversold (below 20.00) region.
- Buy signal = %K line crosses %D line from below in the oversold territory.
- Sell Signal = %K line crosses %D line from above in the overbought territory.
The above chart shows, bitcoin dropped 11% after the stochastic generated a sell signal on June 9. Further, it rallied more than 8 percent after the stochastic charted a buy signal on June 29 (green arrow).
Note that stochastic tends to work best in broad trading ranges or slow-moving trends.
Stochastic: a leading indicator
Still, the stochastic is one tool of many.
The difference between a leading indicator such as the stochastic or Relative Strength Index (RSI) and a lagging indicator such as Moving Averages or Bollinger Bands is that the leading indicators precede price movements, while lagging indicators follow price movements.
Their usage also differs during trending and non-trending periods because lagging indicators tend to focus more on the trend and produce fewer buy and sell signals than their leading counterparts.
READ: CoinDesk's Candlestick Guide can give you the basic building blocks to use this tool.
Charts via Shutterstock