George Lane designed the Stochastics indicator in the last 1950s, as a tool for gauging the relationship between an asset’s closing price and its price range over a specified period of time.
As a well-known momentum indicator, the Stochastics indicator is widely used by traders to spot possible trend reversals.
The indicator was originally designed to follow the speed or momentum of price, it’s now more widely deployed to spot overbought and oversold market conditions.
The Stochastics oscillator is essentially made up of two lines i.e. the indicator itself is represented by the %K, a 3-day simple moving average which is labelled the signal line of the %D line.
The intersection of these two lines signals a possible trend shift is in the cards.
Trading the Stochastic Indicator
The concept of the stochastic indicator is to alert us when price is overbought or oversold. The indicator is scaled from 0 to 100.
Readings on the stochastic indicator that shows it above the 80 level (the upper silver horizontal line), hints to an overbought market condition, and while readings below the 20 level (the lower silver horizontal line) signals an oversold price condition.
As a rule of the thumb, a buy trigger is initiated when an asset’s price is oversold, and a sell alert is triggered when an overbought market condition is in place.
When crossovers occurs within these outer ranges, traders generally consider them to be strong signals.
When formulating a trading strategy that is based on the stochastic oscillator, it is profitable to go for forex pairs that exhibit a distinct and extended bullish trend.
Your preferred pick should be such that has already spent some time in the overbought zone, with price hitting a prior resistance zone.
Lookout for diminishing volume as a supplementary signal for bullish exhaustion.
As soon as the stochastic indicator declines below the signal line, lookout for subsequent price action.
Nonetheless these combined triggers are solid indicators of imminent reversal, pause for price to endorse the bearish turn before initiating an order – this is due to the fact that momentum indicators often issue false alerts from time to time.
The %K line and the %D line of the stochastic indicator are used as measuring tools and it is the %D line that we monitor closely, since it shows any major signals on the activity chart.
The %K line is represented mathematically as follows:
%K = 100[(C – L5close) / (H5 – L5)]
C = the most recent closing price
L5 = the low of the 5 previous trading periods
H5 = the highest price traded during the same 5 day period.
The very important %D Line is represented mathematically as:
%D = 100 * (H3/L3)
This formulas depicted here are merely for curiosity sake.
Charting software that are found on nearly all trading platforms will perform all the calculations on your behalf, making the entire technical analysis method quite stress-free and thereby more thrilling for the average market participants.
Understanding Basic Stochastic Signals
1. Search for Crossovers at Extreme Zones
Traders will logically not want to initiate orders at every instance an alert gets dished out.
Naturally, some signals are stronger than others, and taking stochastic crossovers at extreme levels can be a great filter.
Bearing in mind the stochastic is bound between 0 and 100, overbought is measured above the 80 level, while the oversold region is considered below the 20 level.
When a downward cross occurs beyond the 80 level, it is signaling a possible reversal in trend lower from the overbought conditions.
Similarly, if an upward cross gets displayed below the 20 level, it is an indication of a possible bullish trend from the oversold region.
2. Trade Filtering in the Overall Trend Direction
Stochastic indicator can act as a trend filter when trading on higher timeframes.
If we locate a very strong uptrend or downtrend, the stochastic indicator is likely to stay in overbought or oversold territories respectively for a protracted period of time, while issuing numerous false sell or buy alerts.
It is important to stay away from selling a strong uptrend or buying a strong downtrend, since more pips can still be made in the trend’s direction.
If in any way we locate a strong uptrend or downtrend, we should look for a correction to go bullish or bearish.
We should therefore be in the lookout for correction of our intraday chart to reveal oversold or overbought readings respectively.
If at this instance, the stochastic indicator crosses down from the overbought region, then the buying pressure and momentum is almost certainly eased.
This gives us a sell alert which is in agreement with the bigger picture i.e. sell.
In the EURUSD chart below, prices were well below the 200 Day Simple Moving Average (the blue line that runs across the chart).
For that reason, if trades gets filtered in line with the trend on the 1-Day chart, then only the short signals will be considered.
Consequently, market participants employ Stochastic to time entries for orders in the direction of the overall trend.
Stochastic trading strategies for scalpers
Scalpers who are keen on using the stochastic indicator do so because they want to trade only extremes i.e. they wish to look for zones where the market has overextended.
This implies that scalpers only want to buy at extremely oversold markets, and sell at extremely overbought markets as well.
And of course, as scalpers, we are always looking for avenues where price will react quickly to our levels, and these extreme levels provide such spots.
The stochastic indicator are good at revealing those extreme market levels where price has overstretched itself and the current price is unable to hold itself.
A deep correction or a general market reversal should be our next target.
These levels will offer us the best entries to either buy or sell at oversold or overbought levels respectively.
To formulate an effective scalping strategy, we must use a fast-paced stochastic oscillator and not the default parameters.
This is because a fast-pace stochastic indicator is best suited for lower periods than the one on default settings.
The default setting is 14 periods, but we would deploy 5-7 periods stochastic.
The reason why we want to use a reading of 5-7 on the %K line is because we want them to react very fast as a result of the timeframe we are trading on.
We have highlighted here a stochastic scalping strategy for your interest.
Stochastic trading strategies for day traders
The stochastic indicator can be used for day trading simply by modifying the number of time periods found in its default settings.
A slow-paced stochastic is recommended for day traders because it cuts down the likelihood of entering a position based on a false signal.
On the whole, day traders should use a slow stochastic indicator in order to gauge the comparative position of the latest closing price to the high and low over the last 14-periods.
The main notion for day traders is that an asset will trade around the peak of the trading range during a bullish signal and close to the trough during a bearish signal.
A stochastic indicator is quite useful in spotting such scenarios and we have an example here to further highlights its usefulness.
Stochastic trading strategies for swing traders
For our swing trading strategy, we would deploy a sensitive setting that is suitable for spotting short-term retracement trades, hence we would use a reading of 5 on the %K line.
Combining the stochastic oscillator with a high-quality candlestick pattern will yield a suitable swing trading strategy.
Swing traders use gaps as tools for revealing precious market clues. An examples of such pattern is the Morning/Evening Star candlestick pattern and we have detailed an example here.
Most technical traders use stochastic oscillator as their preferred indicator due to its finding accuracy.
Both seasoned traders and new market entrants have the same notion, and it have a tendency to aid all traders make decent entry and exit decisions.
At some point, we talked about the slow-paced stochastic indicator and how it performs well at spotting primary trends.
If you push things further down the line and mix a few technical analysis techniques i.e. candlestick patterns or trendlines, you’ll see firsthand some hidden market opportunities.
Simply applying an indicator like the stochastic oscillator to your trading charts will not yield good trading results.
Adding basic tools like support and resistance trendlines will allow you make more sense off your trades and give you something to trade against.
They obviously will keep you away from making risky trades, and having indicators that complement each other.
For instance, having two technical tools that perform similarly, will only add a layer of complexity to any trading strategy.
So many forex traders use the stochastic oscillator in a lot of ways, but the primary purpose of the indicator is to decipher when market conditions are overbought or oversold.