Stochastic Oscillator Strategy

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Among oscillating technical indicators, a stochastic indicator is a group whose values fluctuate within a fixed range around a centerline and are calculated using a fixed number of periods. In varying market conditions, beginner Forex traders have difficulty interpreting stochastic oscillator strategy correctly.

The stochastic technical indicator needs to be read differently under a range-bound market condition instead of when the market is trending. In this lesson, you will learn how to interpret the stochastic indicator signals, apply the signals correctly to different market conditions, and calculate the stochastic indicator signals correctly if you have been frustrated by implementing the Stochastic Oscillator.

What is the stochastic indicator?

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An indicator of momentum, the stochastic oscillator compares a closing price of an asset to a high-low range over some time. The Stochastic Oscillator works on the principle that momentum precedes price movements so that it can warn you before the price moves.

An oscillator that operates between 0 and 100 by default, the stochastic is a range-bound oscillator. The indicator displays two lines – the %K line, which oscillates slowly, and a moving average of %K called %D. A period of 3 is typically applied to the indicator’s default setting when slowed.

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The stochastic oscillator formula

For the Stochastic Oscillator, we calculate the %K and %D lines as follows:

  • %K = 100 [(C – L14) / (H14 – L14)]
  • C represents the closing price for the current day.
  • From the previous 14 trading sessions, L14 was the lowest price.
  • When reviewing the previous 14 trading sessions, H14 has the highest price.
  • The currency pair’s market rate is measured by %K
  • %D is the three-period simple moving average (SMA) of %K. Stochastic slow is also called the ‘slow stochastic’ due to its slow reaction to market price changes compared to %K.

There are four standard periods, but these can be changed in the indicator settings to meet different needs, as seen in the above image.

Stochastic divergence

To detect a trend reversal, it is crucial to understand Stochastic divergence.

A bullish divergence occurs when the price makes a lower low and the Stochastics make a higher low. Conversely, whenever the Stochastic is making a lower high than the price, this is called a bearish divergence.

Divergence will almost always follow after a sharp price move, either upwards or downwards. A divergence is merely a signal that the price might reverse and is usually confirmed by breaking a trend line. In the example below, a bullish divergence with a confirmed trend line breakout can be seen:

How do I use the stochastic oscillator to create a Forex trading strategy?

The stochastic oscillator is a momentum indicator commonly used in Forex trading to pinpoint trends about to reverse. This indicator measures momentum based on the closing price compared to the range.

Charts of stochastic oscillators, such as this one, actually have two lines: the indicator itself, which is %K, and the signal line, which is the SMA of %K for three days, called %D. The intersection of these two lines indicates a possible trend shift.

For example, in a chart of a pronounced bullish trend, a low cross through the signal line indicates that the closing price is close to the lowest low of the look-back period than in the previous three sessions. If prices plunge suddenly to the lower end of the trading range after sustained upward movement, it might mean that bulls are losing steam.

Like other range-bound momentum oscillators, the stochastic oscillator helps determine overbought and oversold conditions, including the relative strength index (RSI) and Williams %R.

Stochastic oscillators range from 0 to 100, with readings over 80 representing overbought conditions and readings under 20 reflecting oversold conditions. A crossover in these outer ranges is considered a powerful signal. However, traders often ignore crossover signals other than those occurring at the outer ranges.

Look for currency pairs that have exhibited a clear and lengthy bullish trend when creating trade strategies based on the stochastic oscillator in the Forex market. The overbought territory has already been observed, with the price approaching a recent resistance level.

As another sign of bullish exhaustion, look for waning volume. Watch for the price to move along the signal line when the stochastic oscillator crosses below. Momentum oscillators tend to throw false signals from time to time, so wait for a price confirmation before entering, even if these signals indicate an impending reversal.

Combining this setup with candlestick charting will enhance your strategy and more control over your exit and entry points.

Effective use of Stochastic Oscillator explained.

Forex traders can choose from three different signals provided by the Stochastic Oscillator.

  • Overbought and Oversold
  • Stochastic Crossover
  • Stochastic Divergence

All behave differently depending on the market conditions. Therefore, before you attempt to analyse the Stochastic Oscillator signals, you must learn to recognise the market conditions.

Identifying overbought and oversold market conditions with Stochastic Oscillator

Overbought and oversold market conditions are commonly used as Stochastic Oscillator signals. In our previous discussion of the stochastic oscillator, we mentioned that its value stays between 0 and 100.

The Stochastic Oscillator reading above 80 indicates that the market is overbought. As a result, you should reduce your position size or actively look for opportunities to sell the underlying asset if you already own an extended position.

By contrast, when the Stochastic Oscillator reading goes below the reading of 20, we are in an oversold market condition. Therefore, we should reduce our positions or actively seek opportunities to buy the underlying asset.

The Stochastic Oscillator generates extremely reliable overbought and oversold signals, but it’s worth noting that they work best during a range-bound market.

Stochastic Oscillators give the illusion that the market is about to reverse when the market is in an uptrend. On the other hand, when the market is in a downtrend, the Stochastic Oscillator gives the illusion that the market will reverse. George Lane referred to this phenomenon as the “Stochastic Pop.”

Beginners use Stochastic Oscillator signals to signal overbought or oversold conditions, resulting in a loss when they place to buy or sell orders during an uptrend or downtrend. You will get beaten severely in a trending market using stochastic oscillator signals for counter-trend trading.

Before taking Stochastic Oscillator counter-trend signals seriously, you should confirm trend endings or reversals with additional filters such as trend lines and other trend reversal indicators.

Trading with stochastic oscillator crossover signals

A crossover signal occurs when the %K line crosses above the %D line, generating a buy signal. This is the second most-used Stochastic Oscillator signal. Alternatively, when the %K line crosses below the %D line, it indicates a sell signal.

These Stochastic Oscillator crossover signals are accurate during a range-bound market, but they become less accurate during a strong trend.

The crossover signals of the Stochastic Oscillator can still be considered a trend continuation signal and be used to open additional positions.

For example, the Stochastic Oscillator generated a crossover buy signal in the figure, as the GBPUSD is an uptrend. As a result, the market continued upwards as the uptrend is likely to continue. The crossover sell signal can also be relied upon as evidence of the likelihood that a downtrend will continue if it occurs during a downtrend.

This type of trend continuation signal is generally reliable when markets are trending. However, to prevent losing money when trading against the trend, you should apply additional filters before using the Stochastic Oscillator crossover signal.

Signals produced by the stochastic oscillator can also be classified as divergence signals. The stochastic oscillator can generate divergences during trend reversal and trend continuation. The trend reversal signal is called a regular divergence signal, while the trend continuation signal is hidden. Stochastic divergence signals are generally considered the most powerful and reliable of all stochastic signals.

Trading regular and hidden stochastic oscillator divergence signals

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The stochastic oscillator makes a higher low when the price makes a lower low, but the stochastic oscillator does not confirm it, a Bullish Stochastic Divergence signal. Conversely, the stochastic oscillator does not confirm the high price, making a lower high, called a Bearish Stochastic Divergence signal. A divergence signal that indicates the reversal of a trend is known as a trend reversal signal.

This created a classic regular bullish divergence, as shown in the figure. The GBPUSD price was going down while the Stochastic Oscillator was moving up, as shown in the figure.

This type of market condition, known as regular bearish divergence, occurs every time the Stochastic Oscillator generates a bearish signal, and the price of GBPUSD rises significantly.

Thus, if you observe a regular divergence in the market, you should apply an uncorrelated second signal, such as a price action signal. According to the figure, assuming you had decided to exit the trade when you observed the bearish divergence after noticing the regular bullish divergence, the trade would have been profitable.

The Stochastic Oscillator can be used to analyse hidden divergence as a trend continuation signal. You can reap good trading opportunities by learning how to combine the crossover signal and hidden stochastic divergence.

This is a hidden bullish divergence when the price makes a higher low while the oscillator makes a lower low. Additionally, a hidden bearish divergence will occur when the oscillator makes a higher high while the price makes a lower high.

A combination of Stochastic Oscillator trend continuation and hidden divergence signal is an effective way to use the hidden divergence signal. Combined with a Stochastic Oscillator crossover, a hidden divergence in the market can lead to a high probability trading setup. For example, the pattern indicates that as soon as the %K line crossed the %D line, the GBPUSD price resumed its upward trend.

FAQs

  1. What are the best settings for the stochastic oscillator?

For OB/OS signals, 14,3,3 is a good stochastic setting. The higher the timeframe, the better, but usually, an H4 chart or a Daily chart is best for day traders and swing traders.

  1. Which indicator works best with stochastic?

In addition to the stochastic oscillator, momentum oscillators and moving average cross-overs are significant technical indicators. In addition to stochastic oscillator cross-overs, moving average cross-overs are also available.

  1. How does a stochastic oscillator work?

Stochastic oscillators are momentum indicators that compare one particular closing price to a range of similar prices over a given period. If you adjust that period or take a moving average of the result, you can reduce the oscillator’s sensitivity to market movements.

Bottom line

Trading with the stochastic indicator has been tried by many Forex traders. With this indicator, you can gauge price movements accurately in trending and range-bound markets.

For example, stochastic trading systems can generate reliable buy or sell crossover signals during range-bound markets and identify hidden divergences in trending markets.

As a trend reversal signal during a strong uptrend, the crossover signal is unreliable. However, it can be highly reliable when there are regular divergences.

Stochastic Oscillators can be highly versatile within your trading arsenal. A stochastic oscillation strategy can generate sound signals whether the market is trending or range-bound. However, to trade successfully with them, you must understand how to apply them to varying market conditions.

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