Every new trader has one time or the other come across the stochastic oscillator indicator. It is a very resourceful indicator that is very easy to use.
The stochastic indicator is a momentum indicator that was developed in the late 1950s by Dr. Gorge Lane.
Lane, over the course of numerous interviews, has said that the stochastic oscillator does not follow price or volume or anything similar. He indicates that the oscillator follows the speed or momentum of price.
It compares the recent closing prices of a currency pair, stock, etc. to the highest and lowest prices during a specified period.
The changes in prices during this specified period are used to predict potential reversals. Its sensitivity can be adjusted by reducing or increasing the time period.
Also, the stochastic indicator has overbought and oversold regions bounded within a scale of 1-100.
Generally, sells are taken in the overbought region while buys are taken in the oversold region.
How The Stochastic Oscillator Works
On a stochastic chart, some values are displayed.
“%K” stands for the current value of the stochastic indicator. It can be calculated by;
CP = Closing price of the period
LP = Lowest closing price of the period
HP = Highest closing price of the period
To further explain this, the values of K and D is assumed to be 14 and 3 respectively. These are usually the default settings of the stochastic.
Assuming the current closing price is 55, the lowest price of the period is 40, and the highest price of the period is 60.
To calculate the reading, the lowest price of the period is subtracted from the closing price. This is the numerator of the stochastic formula.
Then, the lowest price of the period is subtracted from the highest price. Which is the denominator of the formula.
The result is multiplied by 100 and this gives the reading for that period.
That is; (55-40) / (60-40) * 100 = 75.
Here, the reading is just shy of the 80-mark indicating that no reversals may occur just yet.
Low readings, below 20 shows that price is near its low for that period.
High readings, above 80 shows that price is near its high for that period.
Stochastic Oscillator Buy and Sell Signals
As I said earlier, the indicator has a range of 1 to 100. Potential trend shifts can be identified depending on the readings of the oscillator.
Stochastic Sell Signal
When readings are above 80 it is in the overbought range. This means higher prices have been achieved for quite a while and a reversal might be on the way.
To illustrate this, the AUDUSD currency pair was backtested:
Here, the indicator’s reading is above 80 which shows that price is nearing its high for that period.
From this information, a sell order can be placed.
A forex trader who uses the stochastic oscillator will exit this trade once readings are below 20.
Stochastic Buy Signal
Conversely, when the stochastic line is below 20, it is in the oversold range. This means lower prices have been achieved for quite a while and a trend reversal might be on the way.
Backtesting with the AUDUSD currency once more:
A buy order will be taken because the stochastic line is below 20.
The position will be closed as soon as the stochastic gets to the overbought region.
However, there are times when the stochastic remains in the overbought/ oversold regions for an extended time when the trend is strong.
A less popular way to trade with the stochastic is with divergences.
Divergence occurs when the stochastic indicator forms highs and lows that diverge from the current highs and lows on the price.
Moreover, divergences are less probable. By analyzing past data, it will be noticed that failed divergences cannot be found.
This is because as the price progressed, it no longer appeared as a divergence.
A bullish divergence occurs when the stochastic forms two rising lows but the price forms two falling lows.
When the stochastic forms a series of two falling highs that corresponds with two rising highs on the price, it is a bearish divergence.
The two lines graphed by the stochastic are %K and %D. %K is the fast oscillator and %D, a moving average of %K.
The best setting for day traders and scalpers is the 14, 3, 3. This is always the default setting of the stochastic oscillator on every platform.
The value of an indicator is subjective to the trader in question. But, overall the MACD is more flexible and versatile.
The stochastic oscillator is a momentum indicator that is used to predict market reversals.
Summary – How To Use The Stochastic Oscillator
The stochastic indicator tends to give false signals sometimes. Buys should not be taken every time the stochastic is in the oversold region.
Likewise, sells should not be taken every time the stochastic is in the overbought region.
Other means of confirmation should be employed. Although, fake signals can also be reduced by only taking signals that line up with small market ranges.