What is the Stochastic Forex Indicator on MT4?

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Right through this guide, we will have an in-depth discussion about the stochastic forex indicator on MT4. Stochastics was developed in the late 1950s by George Lane, and it measures how closely an issue’s closing price is related to its price range over a predetermined period.

Since stochastics are easy to use and have high accuracy, they are still favoured as a technical indicator.

Technical indicators such as stochastics are popular because they are easy to understand and accurate. For example, stochastics determine if a stock is oversold or overbought.

In addition to stochastics, a relative strength index (RSI) can be used in combo with stochastic.

Stochastic Oscillators Technical Indicators at MT4

Overview

Forex traders use stochastic oscillators to spot potential trend reversals. Momentum is measured based on a period’s closing price and the trading range.

There are two moving averages on a stochastic oscillator chart: the indicator itself, called %K, and a signal line, the SMA of %K for three days, known as %D. It signals a trend shift when these two lines cross.

A downward crossing of the signal line, for example, indicates that the most recent closing price is nearer to the lowest low than it was the previous three sessions in a chart with a bullish trend.

After sustained upward price action, a drop to the lower end of the trading range may signal that bullish momentum is waning.

With SMI, curves are built around a zero line and move forward or backwards. A smoothed or fast curve is one of the curves, and a short-term curve is the other. The difference between these curves is their period.

There are plenty of fake signals provided by the SMI for directional movement. For example, stochastic momentum is a good indicator for entering and exiting the market when the market is flat. Nonetheless, even in such a case, the SMI should be used alongside other technical tools.

The formula for stochastic oscillators

For the Stochastic Oscillator, the %K and %D lines are calculated as follows:

The %K value is 100 [(C – L14) / (H14 – L14)]

• C is the closing price at the time of writing
• According to the 14 trading sessions in the past, L14 represents the lowest price
• Based on the 14 previous trading sessions, H14 is the highest price
• For each currency pair, %K shows the most recent market rate

The simple moving average (SMA) of %K over three periods is %D. It is also known as the stochastic slow because it reacts to changes in market prices more slowly than %K.

You can also change the periods based on your needs in the indicator’s settings.

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Stochastic indicator: how to read it

According to the stochastic oscillation in the market, if the reading above 80 shows overbought market conditions and if the reading below 20 shows oversold market conditions, the market is overbought.

A reading over 80 in a standard 14-period setting means that the currency pair is overbought, and the market will reverse. Additionally, if a currency pair reads below 20, it is in oversold territory.

During a strong market, use this indicator with care. During this time, the indicator remains in either overbought or oversold territory. To get genuine and accurate signals in the market, stochastic is recommended to be paired with the other indicators.

Reading Stochastic Indicator in MT4 trading

Describe the stochastic indicator’s workings

Based on the closing price of an instrument and the price range over several past periods, this indicator computes the direction of movement in the market. This indicator typically takes into account 14 previous periods.

The indicator attempts to predict price reversal points by comparing the closing price with previous price movements.

You can use the stochastic indicator on any chart since it is a two-line indicator. Stochastics fluctuate between 0 and 100. Using this indicator, you can see how the current price compares to the highest and lowest prices over a specified period.

There are typically 14 separate periods in the previous period. A weekly chart, for example, would have 14 weeks. This would be equivalent to 14 hours on an hourly chart.

A white line appears below the chart when the stochastic indicator is applied. We call this the %K line. The chart will also show the moving average of %K for three periods. This is also known as the %D.

Pros & Cons of the Stochastic Indicator

Pros

• Setup and use are easy
• Divergence, overbought/oversold, bullish/bearish patterns, among others
• Suitable for any trading asset and any timeframe
• Trading strategies abound
• It can be combined with other tools of technical analysis
• Frequently used. Easily accessible from any platform.

Cons

• When the settings are wrong, fake signals can occur
• Combining other tools is the only way to achieve high accuracy

The Stochastic indicator as a trading strategy

A leading indicator is stochastic, as we already know. This is the indicator that most traders use alone when trading. However, you will have a greater edge in the market if you combine this indicator with other indicators. The following strategies are some of them.

Strategy 1

1.     Stochastic + moving averages

We trade GBPUSD using the Stochastic and simple moving averages using this strategy. In addition, the Stochastic indicator is set with default settings.

The combination of these two factors will generate trading signals. For example, during an overbought/oversold state, the stochastic indicator should give a sharp reversal.

If the 9-period moving average crosses the 5-period moving average, the item is in buy territory.

As moving averages work best only in trending markets, we recommend using this strategy only when the market is trending.

2.   Selling strategy

Imagine if the GBPUSD was in pullback mode. Stochastic gave the sharp reversal after the moving averages crossed. Selling is recommended here.

When the first signal from this strategy came in, you could have made 40 pips in the market if you had sold. The market would have moved 50 pips in your favour if you had taken a sell at the second signal this strategy gave us.

GBPUSD provides us with two potential selling signals in a single day. Traders have used the strategy for years.

3.   Buying strategy

This strategy gives us three buy signals in the CHFJPY 15 M chart. First, a crossover of the moving averages occurred when the Stochastic retreated from the oversold area. The trading signal is constructive.

The first, second, and third trading signals would have resulted in 20 pips, 25 pips, and 30 pips profit.

Strategy 2

1.   Stochastic + RSI strategy

Stochastic and RSI divergence will also be combined to generate potential trading signals. The Stochastic Indicator is paired with the Relative Strength Index in this strategy. Both pairs should be overbought/oversold simultaneously for a signal to appear.

Using the EURCHF 60 M chart, both indicators reached overbought territory and reversed sharply, giving a sell signal. When any indicators reach the oversold level, you can close the trade.

When both indicators reach the oversold area and reversal sharply, as seen in the EURCAD 60 M chart below, it is a buy signal.

2.   Stochastic and RSI divergence strategy

Divergence occurs when the price moves in one direction, but the indicator moves in another. This is a sign that the market is about to reverse.

The EURNZD 60 M chart shows that both indicators find it difficult to rise, and the price is losing momentum. This is an excellent indication of a series of trend reversals.

What is the default setting of a stochastic indicator?

The stochastic indicator is set to ’14’ by default, regardless of the time frame. Charts can be viewed hourly, daily, weekly, monthly, or intraday.

%K is the 3-day simple moving average of %D. With 14 periods, %K is calculated using the latest close, highest high, and lowest low for each period. Additionally, the %D line serves as a signal line in conjunction with the %K line.

Default Setting of Stochastic Oscillator Indicator

RSI vs. stochastic oscillator

Comparing stochastic oscillators with relative strength indicators (RSI) is common. They are both popular indicators. Professional traders widely use both indicators. However, they also share the following similarities:

1. It is an oscillator.
2. It shows how fast the price changes.
3. These indicators provide the same signals: zones of overbought and oversold conditions, divergence, and convergence.
4. Their flexibility makes them applicable to any market and any timeframe.

In the meantime, they have many differences:

1. Setup. The moving average period is the only setting of the RSI. Stochastics have four parameters.
2. Stochastics have unique signals. A cross of the stochastic oscillator’s %K and %D curves is widely used by traders. An RSI indicator is not smoothed with a moving average. Instead, the relative strength index establishes support and resistance levels. Graphs can be used to analyse this indicator.
3. For the stochastic, overbuy/oversell levels are 80/20; for RSI, 70/30.

Combining the RSI and stochastic oscillator is not advisable for beginners. Their underlying principles are the same. The signal will not differ significantly. The high frequency of alerts and false signals will probably confuse you if used together.

However, stochastic and RSI cannot be compared. Therefore, both are valuable to traders and cannot be reached.

How to use a stochastic oscillator when trading the S&P 500 and the dollar

Instruments behave differently. When trading, you need to keep this in mind. Throughout this article, we will examine stochastic trading features for S&P 500 futures, gold, and the U.S. dollar.

1.   Trading the S&P 500

If we look at the price movement of this instrument historically, we see that the price declines don’t always coincide with a stochastic move to overbought territory. The market is more likely to rise if the indicator is oversold and vice versa.

During a temporary oversold trend, a bullish reversal signal can work well. But, conversely, the market is likely to enter an overbought area in a downward trend when a bullish correction occurs.

2.   Gold trading

Even with a line crossing, overbought/oversold signals are not recommended when trading gold.

Signals for a bullish reversal normally do not work if the market is temporarily oversold in the uptrend. Conversely, the market is likely to reverse in a downtrend when temporarily overbought.

3.   U.S. dollar trading

Using a stochastic strategy to fix overbought and oversold conditions won’t work for USD in an uptrend or downtrend. In the case of curves entering the overbought or oversold territory, the dollar often moves along with the momentum. So, you should enter during a price reversal.

Related questions: FAQs

1.   Which stochastic setting is best for a 5-minute chart?

5-minute charts should use minimum periods of %K and smoothed lines. The most common settings are (5, 3, 3). The majority of them are useful, as they allow us to obtain sufficient signals. But (7, 3, 3) parameters are rarely used.

2.   How do I set up my stochastics for day trading?

Smooth lines by setting larger periods for %K. In this way, you can avoid false signals. Use the (9, 3, 3) settings if you rely on frequent alerts for your stochastic oscillator trading strategy. The (14, 3, 3) and (21, 3, 3) parameters are optimal if the signs’ reliability is the main concern.

3.   What are the benefits of stochastic oscillators?

A classic indicator is a stochastic oscillator. Although it was invented in the 1950s, traders still use it extensively today. Many traders, however, do not rely on the stochastic oscillator alone. Instead, stochastics are most often used in conjunction with another technical analysis tool in successful trading strategies.

4.   In a stochastic oscillator, what is a period?

Stochastic oscillators are typically measured by their period, corresponding to the %K curve. It is used to determine the price range. Stochastic oscillators affect the mainline by changing its sensitivity. The stochastic oscillator’s settings also indicate the periods of smoothing of %K and %D lines, a moving average of %K.

5.   Is RSI or a stochastic oscillator better?

It depends on the selected trading strategy. Both indicators help determine when the asset is overbought and oversold. They both provide false signals even with optimal settings. They are generally used in conjunction with other tools. Several traders still rely on them as part of their classic technical analysis.

Bottom line

Technical analysis instruments are not 100% accurate. Stochastic indicators confirm this. Stochastic indicators provide plenty of signals, but they are not always accurate.

Today, the stochastic oscillator is regarded as a perfect addition to any strategy, regardless of its invention. Moreover, because it has so many adjustable parameters and the supplied signals are so simple, the stochastic oscillator makes a great tool. Therefore, it should be practised so you can obtain accurate trading signals.

jason

Jason Morgan is an experienced forex analyst and writer with a deep understanding of the financial markets. With over 13+ years of industry experience, he has honed his skills in analyzing and forecasting currency movements, providing valuable insights to traders and investors.

Forex Content Writer | Market Analyst

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