Stochastic Oscillator Settings
The Stochastic Oscillator was introduced in the 1950s and remains one of the most popular technical indicators used in Forex and stock trading today due to its versatility.
This article will explain the Stochastic Oscillator settings, show how they can be used for online trading, and share the best settings for stochastic indicators for day trading and swing trading.
In addition, we provide you with a stochastic oscillator trading strategy for scalping, day trading, and swing trading!
What is a stochastic oscillator?
The stochastic oscillator indicates technical analysis that shows the dynamic changes between the closing price and too many prices.
The primary function of this trading tool is to determine market patterns such as:
- local surplus;
- start and end of the trend;
- convergence and divergence;
The premise is that the closing price still stays at the previous local maximums for a while in the bullish trend and stops at the level of prior minimums in a bearish trend.
Stochastic oscillators are effective when used on a 1-minute timeframe and on hourly, daily, or weekly timeframes.
The formula for calculating stochastic oscillator
A stochastic oscillator is a combined component of lines “Slow Stochastic” and “Fast Stochastic.” It is divided into three variants that monitor behind time and data level range.
- Fast %K represents the closing price by comparing with previous periods.
- %K slows down fast %k with a simple moving average
- %D adds a second average
- C is the current closing price
- The lowest low is the lowest for the time frame
- Highest High is yet the highest high for the time frame
FCA, FSCA, ASIC, SCB N/A USD 1 1:200
FCA, FSCA, ASIC, SCB
What are the fundamental limitations of stochastic oscillators?
The Stochastic Oscillator’s primary limitation is the tendency to give wrong signals. This is mainly during stubborn and highly volatile trading situations.
So it’s essential to wait for a confirmation of the signal from the Stochastic Oscillator and other technical indicators.
The Stochastic Oscillator was invented mainly to measure power and weakness, not the trend.
By using utmost readings from the Stochastic Oscillator indicating an overbought or oversold situation in the market, some traders target to reduce the oscillator’s tendency to give false signals.
Traders can mix different oscillators such as the MACD or the RSI with the stochastic oscillator. This will help improve the signals of our business strategy.
Guide on different types of stochastic oscillators
Recently, there are two types of Stochastic Oscillators used by technical traders in today’s trading. This is-
- Fast Stochastics
- Slow Stochastics
In terms of appearance, two of these differences are almost identical, but there are many differences in the way these two differences are calculated.
As per your trading style and the market conditions in which you trade, the ideal Stochastics option will vary according to your needs.
Slow Stochastics is known to smooth out spurious signals and is therefore considered reliable. On the other hand, fast Stochastics are sensitive to changes in price trends and thereby prove more reliable in certain market conditions.
Irrespective of how these two variations of the Stochastic Oscillator are calculated, they share the same structural components. Thus, the trading signals generated by these variations are read and interpreted the same way.
Therefore, even though you can choose either of the two stochastic types depending on the market conditions you are trading in, the overarching principle of using, interpreting, and incorporating into your overall trading strategy will remain the same.
What should you know about the best stochastic oscillator settings?
First, you have to choose how much noise of data you’re ready to accept for your trading method. Then, the more knowledge you have with the indicator, it will enhance your understanding of probable signals.
Some professional traders choose a lower condition for short trading than scalping. Conversely, some merchants choose high settings for long trades. This is because a very smooth result will only respond to factors that change the price action.
The Stochastic Oscillator comes with standard settings 5.3.3. Other common settings are 8.3.2 and even 14.3.3.
Now, depending on your trading style, you need to decide how big a sound you are willing to accept with Stochastic.
Short values for the stochastic oscillator will cause the indicator to be too sensitive. On the other hand, stochastic with a low setting will give a lot of signals, but there will also be a lot of noise on the market.
Higher values for the stochastic indicator will make it less sensitive to market noise. This will somehow lead to fewer signals as the signal will be smoothed.
How to read a stochastic indicator?
The stochastic indicator is on a scale from 0 to 100. A value above 80 means that the instrument is trading near the top of its upper and lower range! But a value below 20 means that the instrument is trading near the bottom of its upper and lower spreads!
Values above 50 indicate that the instrument is trading within a high trading margin. Conversely, values below 50 indicate that the instrument is trading at the lower end of the range.
If the stochastic lines are above 80, the indicator indicates that the tool is overbought. If the stochastic lines are less than 20, the instrument is for sale.
Overbought and oversold levels help predict trend changes.
If the stochastic indicator falls from a value above 80 below 50, the price is lower. Conversely, the price is higher if the indicator moves from a value below 20 to above 50.
Entrepreneurs are also looking for a difference. This is when the stochastic trend line and the price trend line move away. This suggests that the price trend is weakening and will return soon.
How to use a stochastic oscillator? Different strategies to follow
1. Stochastic overbought/oversold strategy
In the basic overbought/oversold strategy, traders can use a stochastic indicator to identify the exit and entry points.
In general, traders seek to purchase when the instrument is resold. A buy signal is given whenever the stochastic indicator is below 20 and above 20. In contrast, traders seek a sale when the instrument is overbought.
The sell signal is given whenever the stochastic indicator exceeds 80 and falls below 80. However, oversold labels can be misleading. The instrument does not have to fall in price because it is overbought.
Likewise, the tool does not automatically become expensive because it is oversold. Overbought and oversold mean that the price is traded close to the upper or lower band! These conditions can take a while.
2. Stochastic divergence strategies
Another most common trading strategy using the stochastic indicator is the divergence strategy. In this strategy, traders monitor whether the instrument’s price creates a new high or low, while a stochastic indicator does not. This might be a sign that the trend may be reversed.
A bullish divergence occurs when the price of an instrument reaches a lower minimum, but a stochastic indicator reaches a higher minimum. This suggests that selling pressure has decreased, and an upward turn may occur.
A bearish divergence occurs when the price of an instrument reaches a higher maximum, but the stochastic indicator reaches a lower maximum. This suggests that emerging momentum has slowed, and a downward trend is planned.
An important point about the divergence strategy is that measures should not be taken until an actual price reversal confirms the divergence. This is because the price of an instrument may continue to rise or fall for a long time, even if there is volatility.
3. Stochastic crossover
Stochastic crossover is another well-known strategy used by traders. It occurs when the two lines cross in an overbought or oversold region.
When an increasing %K line crosses above the %D line in an oversold region, it generates a buy signal. Conversely, this is a sell signal when a decreasing %K line crosses below the %D line in an overbought region.
These signals tend to be more reliable in a range-bound market. They are less reliable in a trending market. Traders check the stochastic indicator to ensure it stays in one direction in a trend tracking strategy. It shows that the trend is still valid.
4. Stochastic bull/bear strategy
Finally, another widespread use of the stochastic indicator is identifying measures to trade in bulls and bears.
The setting for bull trading occurs when a stochastic indicator creates a higher high, but the instrument’s price creates a lower high. This suggests that momentum increases, and the tool’s price may rise higher.
Traders always try to shop after a short pull at a price where the stochastic indicator drops below 50 when it pulls back and then moves high again.
The bear trading setting occurs when the stochastic indicator creates a lower minimum, but the instrument’s price creates a higher minimum.
This suggests that selling pressure increases, and the instrument’s price may be short-lived. Traders always try to make a sale after a short price rebound.
Traders should know that the stochastic indicator has limitations. It’s not a foolproof technical analysis tool. The indicator can often generate false signals. During choppy market conditions, this can happen frequently.
How can you improve the reliability of stochastic oscillators in trading?
A stochastic oscillator is considered a pretty reliable oscillator. However, as mentioned above, it generates many signals, and not all signals produced by it are profitable.
Therefore, to effectively integrate this indicator into your overall trading strategy, you need to know how to filter the false signals it generates.
In addition, although the Stochastic Oscillator can be used to improve the accuracy of your actions and other indicators and trading tools, it is rarely effective as a stand-alone indicator.
Due to the above limitations, to use Stochastics effectively, you need to learn how to improve the reliability of their trading signals. Here are four popular ways to improve the reliability of the Stochastic Oscillator in technical trading:
- Adjust the period for the sensitivity change
- Raise and lower the overbought/oversold threshold to 85/15
- Combination of two stochastic oscillators
- Combine a stochastic oscillator with other indicators and tools
Pros & cons
To get the most out of the indicator, traders should know where the stochastic oscillator will work best and its shortcomings.
- It has clear input and output signals.
- Its signals always light up depending on the selected time setting
- This indicator is present in most card decks
- This concept is easy to understand
If not used properly, it can produce false signals. This is when it issues a trading signal, even if the price does not follow, resulting in a trading loss. This can often happen in an unstable market situation.
One way to handle this is to take the price trend as a filter and use indicators only when they are in the same direction.
Frequently asked questions (FAQs)
1. What is a stochastic oscillator?
It’s a momentum indicator used in forex trading to target a potential trend reversal. This indicator measures momentum by comparing the closing price of the trading margin for a given period.
2. What is the best setting for stochasticity?
For the OB / OS signals, the stochastic setting of 14, 3, and 3 is good. A longer time frame is better, but H4 is usually best for daily and swing traders as a daily chart.
3. What is the initial period of the stochastic oscillator?
The default setting for the Stochastic Oscillator is almost 14 periods, which can be days, weeks, months, or an intraday time frame. For example, a 14-period %K would be the most recent close, the highest high over the last 14, and the lowest low over the last 14.
4. How accurate is a stochastic oscillator?
Technical indicators favour Stochastics because they are easy to understand and have relatively high accuracy. However, it still falls into the class of technical indicators known as oscillators. The indicator provides traders with buy and sells signals to enter or exit positions based on momentum.
5. Is stochastic better than MACD?
MACD is usually a more effective indicator of trend markets, while Stochastics will always move better in the markets. We will further examine how traders combine MACD and stochastic indicators to obtain better signals.
You should now be more familiar with the Stochastic Oscillator and understand why it is a popular indicator when trading Forex.
The Stochastic indicator is best when using the standard indicator found on the MT4 and MT5 platforms. Other proprietary stochastic indicators can cause delays and can use different formulas.
Before attempting any of the live trading strategies, it is recommended that you open a demo trading account so that you can practice in a risk-free environment.
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Heinrich is a forex and CFD enthusiast with a passion for writing good informative quality content. He strives to showcase the best forex brokers in Africa. Join him on his Journey!
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