Stochastic Indicator in Trading

The Stochastic indicator was created at the end of the 1950s. However, it’s still popular among traders as the oscillator is an easy-to-use technical tool that provides various signals. In this tutorial, we will discover how you can use it in your trading strategies.

Stochastic Oscillator: What It Is

Let’s begin with an explanation of the Stochastic indicator. Stochastic is an oscillator that shows the price impulse regarding a chosen period. Using the indicator, traders can define correction and reversal market conditions. Stochastic consists of two lines: %K (the fast line) and %D (the slow line). The slow line is the Moving Average of the fast one.

Stochastic Indicator: Settings

The Stochastic Oscillator is a standard technical tool that is implemented into most trading platforms. If you use MetaTrader, find the “Insert” tab on the upper panel, click “Indicators”. Stochastic is an oscillator, so choose “Oscillators”, there, you will find the Stochastic Oscillator.

Now, you need to set its parameters. Stochastic compares the close price to the price of the specified period of the timeframe. The indicator doesn’t require specific settings; standard ones work well. They are 5 for the fast line, 3 for the slow line, and 3 for slowing.

Still, if you are a professional trader, you can try other parameters for your trading strategies. The famous ones are 14 and 21 for %K, 3 and 5 for %D, and 3 and 5 for the slowing.

Stochastic Oscillator: Catch Its Signals

The indicator is loved by traders the world over because it provides simple and reliable signals that work at any time frame.

Overbought/Oversold Conditions

A Stochastic Oscillator is a range-bound indicator. There is a range of 0-100 where it moves. A movement within the specific zone allows a trader to define overbought and oversold market conditions.

For the Stochastic Oscillator, key points are 20 and 80. If the asset is overbought, the indicator will be above 80. It’s a sign of the upcoming price declines. A trader should open a sell trade as soon as the indicator crosses the 80 level upside-down. When the trading security is oversold, the Oscillator moves below 20, signaling the possible upward movement of the asset’s rate. It’s worth opening a long position when the indicator leaves the oversold area.

Lines Crossover

Although the overbought/oversold signals are strong, there are exclusions. If there is a sharp trend, the price may correct for the short term but will keep moving in the trend’s direction.

Here, you should look at a crossover of the indicator’s lines. When the %K crosses the %D line from bottom to top, the price is anticipated to climb. If the %K breaks below %D, the price may decline. These rules work better if the crossovers occur in overbought/oversold zones.

Divergence

A divergence signal is workable for any oscillator. As both price and Stochastic form tops and bottoms, it’s possible to define bullish and bearish divergence.

  • A bullish divergence occurs when the price declines, but the oscillator forms higher lows. There are odds of upward movement. In this case, it’s possible to open a long trade after the signal candle is closed.
  • A bearish divergence is a market condition when a price sets new highs, but the Stochastic curves move down. It’s a sign of the possible price decline. A trader can open a short position after the signal candlestick is closed.

Stochastic Oscillator: Types

There are the three types of oscillators that differ based on their calculation. Here is a brief overview.

Fast

  • Fast %K is %K basic calculation;
  • Fast %D is a 3-period Simple Moving average of Fast %K.

Slow

  • Slow %K is Fast %K which is smoothed with a 3-period Simple MA;
  • Slow %D is a3-period SMA of Slow %K.

Full

  • Full %K is fast %K line smoothed with any-period SMA;
  • Full %D is any-period SMA of Full %K.

The full type is a version of the Slow Stochastic indicator that is fully customized. It’s possible to set a retrospective period, the number of periods for slow %K and the %D MA.

Stochastic Oscillator: Benefits and Pitfalls

The advantages and disadvantages of the indicator will help you decide whether you should apply it to your trading strategies.

Pros:

  • User-friendly tool. The indicator is set fast and without specific knowledge. It’s a standard tool on many trading platforms.
  • Many signals. The oscillator provides various signals, which makes it a helpful trading tool.
  • Effective. The Stochastic Oscillator provides reliable signals regardless of the timeframe and the security you trade.
  • Combines well. As there is no perfect indicator that provides only precise signals, it’s worth combining indicators and chart patterns. The Stochastic Oscillator can be combined with MACD, Moving Averages, Bollinger Bands indicators, and trendlines. 

Con:

  • Any technical tool can provide wrong signals, Stochastic Oscillator is not an exclusion.  Wrong signals occur due to wrong settings and lack of confirmation.

The Stochastic Oscillator is a useful technical tool. It can be applied to define correction and reversal market conditions.

Adam Hansen