A comprehensive look at the Stochastic Oscillator in trading
The Stochastic Oscillator is an indicator that shows the position of the current price related to previous prices in a chosen range. The measurements are carried out in percent.
What is the Stochastic Oscillator?
The author of the indicator is George Lane. He created it at the end of the 1950s. Originally it was designed as an instrument for the stocks market, but later it also became the essential indicator in Forex trading. The idea behind the Stochastic is that in an uptrend each next timeframe tends to close near the previous highs, while in a downtrend, they close near the preceding lows.
Practically speaking, the Stochastic shows the position of the current closing price related to the closing prices of the previous periods in a chosen timeframe.
There are several types of the Stochastic Oscillator: fast, slow, and standard ones. In our case, we will discuss just the slow one with the full range of data because it is the most popular type among traders thanks to smoother values; moreover, it is less sensitive to price fluctuations than the fast one - which decreases the number of false signals. The full Stochastic Oscillator differs from the standard one by having a signal line and the use of averaging the line in the settings.
The Stochastic is comprised of two lines - %K and %D, which move inside the range between 0% and 100%.
Description and calculation of the Stochastic indicator
To calculate the Stochastic, we use the following data:
- %K period is the number of periods used for calculation.
- %K slowing period is the averaging degree of the %K line. Most often, the value here is 3 (in this case, the Stochastic is slow) or 1 (in which case the Stochastic is fast).
- %D periods is the number of periods used for the calculation of a Moving Average to %K.
- %D method is the averaging method of %D.
- The method may be Simple, Exponential, Smoothed, or Weighted.
%K is calculated as:
%K = (CLOSE - MIN (LOW (%K))) / (MAX (HIGH (%K)) - MIN (LOW (%K))) * 100,
Where:
CLOSE is the current closing price
MIN (LOW (%K)) is the lowest low of the %K periods
MAX (HIGH (%K)) is the highest high of the %K periods.
The %D MA is calculated as follows:
%D = SMA (%K, N),
Where:
N is the averaging period
SMA is a Simple Moving Average (may as well be EMA, SMMA, LWMA).
In the screenshot, you may see what the Stochastic looks like:
Pic-1-Stoch
%K is the green line, %D is the red dotted line. As you can see in the picture, the lines fluctuate between 0% and 100%. The area between 20% and 0% is the oversold area, while the zone between 80% and 100% is the overbought area. In practice, the borders of these areas are often shifted according to the volatility, trend, and other details to be accounted for in trading. The levels might as well start at 30% and 70% or 25% and 75%.
When the price reaches the oversold area, it means that it can fall no more, so a pullback or reversal will follow.
When the price reaches the overbought area, it means that it can grow no more, so a pullback or reversal will follow.
The author recommends against buying or selling right away when the price reaches those areas because it may still go in the same direction for a certain time as the oscillator values do not oblige it to reverse.
How to use the Stochastic in practice?
The Stochastic may be used in the following ways:
1. The crossing of %K and %D. A signal to buy emerges when %K crosses %D from below; the lines should be in the oversold area. A signal to sell emerges when %K crosses %D from above, and both lines are in the overbought area.
Examples of buying and selling trades
Pic-2-Stoch-Buy
This is the simplest way of using the Stochastic indicator but its drawback is the abundance of false signals, especially when the price is following the trend while the signal is against it. Always keep in mind that the Stochastic is efficient in a flat and should be used alongside other market analysis instruments or filters.
Pic-3-Stoch-Sell
2. The escape of the Stochastic from the oversold or overbought area. A signal to buy emerges when %K breaks the level of 20% upwards, exiting the oversold area. A signal to sell appears when %K crosses the level of 80% from above, exiting the overbought area.
Very often these signals are combined with the crossing of %K and %D, described above. An additional filter called right-side crossing in literature is also used. The idea of the filter is that a signal is considered valid only when %K crosses %D after the latter has already reversed, and the crossing must be to the right from the reversal.
In this case, the signal to buy appears only when %K enters the oversold area, i.e. descends below 20%, crosses this level from below and simultaneously crosses %D after it has also reversed.
A signal to sell emerges when %K enters the overbought area, i.e. rises above 80%, and then crosses this level from above and also crosses %D. The latter, in its turn, has already reversed. Look at an example of how it happens:
Pic-4-Brent
3. Using a divergence. Under a divergence, we mean the divergence of the Stochastic lines and the price chart. This is the property of all oscillators. The idea is that when the price on the chart shows a new high while the oscillator does not rise above the previous high, the price may soon reverse and start declining. Similarly, when the price on the chart demonstrates a new low while the Stochastic does not drop lower than the previous low, the downtrend may soon change for an uptrend.
An example of a divergence
Pic-5-Stoch-Diver
You should use the Stochastic in a flat, to add to the trend, or to exit open positions at local extremes. I do not recommend opening orders by the indicator against the current trend if there is no divergence and other corresponding signals for your open positions. The Stochastic should be combined with other methods of analysis and used along with other signals for opening positions.
Summary
The Stochastic Oscillator is an efficient instrument, especially good for beginner traders in Forex. Today, I have told you about the simplest signals of this outstanding indicator, that will be helpful, I hope, in comprising your trading system. For sure, the use of the Stochastic in Forex has a lot of peculiarities that we simply cannot discuss in one article.
This article was submitted by Dmitriy Gurkovskiy, Financial Expert and Author at RoboForex Blog
