In this article, you will find the most comprehensive overview of the stochastic oscillator. We will cover its structure, signals, and compatibility with other instruments. Moreover, we will test stochastic trading strategies in practice.
The article covers the following subjects:
- 1 What Is a Stochastic Oscillator?
- 2 How Does the Stochastic Oscillator Work?
- 3 Stochastic Indicator Calculation & Formula
- 4 Stochastic Indicator Interpretation: Reading the Charts
- 5 Real Examples of Using Stochastic Indicator in Forex Trading
- 6 Using a Stochastic Oscillator When Trading S&P 500 and U.S. Dollar
- 7 Combining a Stochastic Oscillator With Other Indicators
- 8 Pros & Cons of the Stochastic Indicator
- 9 Stochastic Oscillator FAQ
- 10 Stochastic Oscillator Conclusions
What Is a Stochastic Oscillator?
The stochastic oscillator is a technical analysis indicator that reflects the dynamic changes between the bar's current closing price and price extremes for a given period.
The instrument's primary function is to determine market patterns, such as:
the beginning and end of a trend;
convergence and divergence;
the beginning of a correction.
The premise of a stochastic oscillator is that the closing price stays at the previous local maximums for a while in the bullish trend and stops at the level of prior minimums in a bearish trend.
The stochastic oscillator formula is considered effective when it is used on a 1-minute timeframe as well as on hourly, daily, or weekly timeframes.
History of the Stochastic Indicator
The stochastic oscillator indicator was invented in 1950 by American stock analyst George Lane.
Once, while observing the price changes, he noticed that there was not a trend but a reciprocating movement that prevailed on the market. So, he developed an indicator that would catch these dynamics and signal reversals in both directions. The stochastic indicator was based on the price bar's major parameters – closing, high, and low prices.
According to one of the theories, there were initially different types of the stochastic oscillator formula. Combinations of price bar parameters and their derivatives were sorted out to determine the best stochastic oscillator formula. Each formula was named by sequential letters of the Latin alphabet: %A, %B, %C, etc. However, only two options, %К and %R, were successful.
A combination of the stochastic indicator %К and its moving average, named D (from the word deviation), became the best option that can spot when the asset is overbought or oversold.
Technically, D isn't stochastic – it is a derivative from %K. However, it is called stochastic and even has a % symbol. This is how the well-known stochastic oscillator was created.
At the same time, the stochastic %R did not disappear. It can be found under the name “%R Larry Williams Oscillator” or simply “R Williams.”
How Does the Stochastic Oscillator Work?
Classically, a stochastic oscillator as a technical analysis tool is represented by two moving curves that move between two levels. Usually, these are 80% and 20%.
The solid orange line in the image above is called %K, and the blue line is the 3-period moving average of the %K curve.
When two lines are above the upper level of 80% (marked with blue zones at the top), the instrument is overbought. When they fall below the bottom horizontal line of 20% (red zones in the bottom), it's oversold. This is how the user can easily spot the overbought and oversold levels of the market.
Line crosses have a special meaning. If it happens in the overbought zone, it’s a signal of a short position. If it is in the oversold area, you should open a long trade to avoid losing money rapidly.
Nevertheless, it's not recommended to trade using only the stochastic oscillator as a momentum indicator. In the simplest stochastic oscillator strategy, signals are filtered by the trend direction. For instance, if a downtrend prevails, open only short positions. If there is an upward trend, place long trades. Combining a stochastic indicator with other trading tools can help the user to spot easier overbought and oversold conditions.
Thus, if we analyze the overbought and oversold levels of the EURUSD chart, we can spot a bearish trend. That's why we look for a point to open a short trade in overbought zones. The stochastic oscillator presents a potential entry point where the red oval is. As there is a crossover of the indicator lines above 80%, a short-term correction should end, and the downtrend will continue pushing the oversold levels lower.
Stochastic Momentum Index (SMI) Explained
In addition to the classic stochastic indicator, a modified version called the Stochastic Momentum Index indicator, or SMI, is widely used. It is also considered a very efficient technical analysis tool that combines the aforementioned tool with momentum, which provides smoother signals and is less dependent on market noise.
In SMI, curves are built around a zero line and move in either a positive or negative direction. One of the curves is called smoothed or fast; another one is short-term. As you can guess, these lines differ by period.
Some of the stochastic momentum indicator’s pros are its reliable entry and exit signals when the market is flat. Still, even in such a case, it's worth using the SMI with other technical tools. As for the directional movement, the SMI uses the last closing price and provides plenty of fake signals.
You can download the Stochastic Momentum Index here.
The standard installation process is via MetaTrader 4. For beginner traders, check the step-by-step explanation using the example of the Bollinger Bands indicator here.
Install and run the stochastic indicator. In the “Input parameters” tab, you can change parameters such as:
- «Period_Q» – a period of the algorithm’s primary curve;
- «Period_R» – primary smoothing of the main line;
- «Period_S» – secondary smoothing of the main line;
- «Signal» – the parameter responsible for the smoothing of the secondary signal curve.
If both the main and signal curves (the green and red lines on the chart above) are above the zero line (blue), the market is overbought; if below, the market is oversold. This way the user can always have a better understanding of the overbought and oversold levels of the market.
A sell signal is formed when the main momentum indicator line crosses the signal line upside-down.
On the chart above, the red arrow marks this moment. If the stochastic indicator breaks the signal line bottom-up (green arrow), open a long position. A stop-loss can be placed slightly below local minimums within several candles from the entry point. Close the position at either a take profit level, which is 2-3 times bigger than stop-loss, or when a reversal signal occurs in order to avoid losing money rapidly.
Stochastic Indicator Calculation & Formula
Let's consider the stochastic oscillator’s formula.
%K is calculated as follows:
- max (Hn) – a top within an n period;
- min (Ln) – a low within an n period;
- C0 – a close price of the current candlestick.
Here’s an example of the Stochastic’s formula that uses three periods.
On the chart, the bar with which we calculate the stochastic indicator is marked with green. The close price is 1,17972. The green line highlights the highest price for the last three candles – 1,17994. The red line marks the lowest price of the previous three candles, which is 1,17948.
According to the stochastic indicator’s formula:
%K = 100 * ((1,17972 – 1,17948)/1,17994 – 1,17948) = 100 * (0,00024/0,00046) = 52,17%
This is how traders used to calculate stochastic readings and used to define the highest and lowest prices. Nowadays, it seems extremely inconvenient.
Alternatively, you can use an automated stochastic indicator, which is integrated into the LiteFinance online platform, MetaTrader 4, or download the stochastic oscillator as an Excel calculator here. The principle of how this calculator works is straightforward. It is like the Excel Bollinger Bands Table (the link to the explained instructions is here).
Stochastic Indicator Interpretation: Reading the Charts
When using the stochastic indicator on Forex trading, there are many signals, including the overbought and oversold levels of the market. That's why this momentum indicator is often used with other indicators for more accurate signals. In the following sections, we will explain the specifics of the stochastic oscillator signal types, methods of interpretation, and detection.
Fast, Slow & Full Indicators
How do you set the stochastic indicator? Usually, the parameters are defined by three meanings. One for each % K, % D, and smoothing coefficient. 5, 3, 3 is one of the classic combinations.
- 5 is a period of %K- the leading stochastic curve. As you might remember, we have already broken down how to calculate this parameter. The stochastic formula looks like this:
The value 5 means that maximums and minimums will be calculated for the last five candles. In the stochastic indicator’s formula, this parameter is presented by n.
- 3 reflects the period of %D, a so-called signal line. It's a simple moving average built on the final parameters of %K.
- 3 is the last parameter of the slow stochastic oscillator. It's used to smooth the %K curve, making it more flowing without market noise. In other words, initial %K is calculated with an averaging coefficient.
In such a case, the formula for %K is as follows:
The %D curve will be built on the average value of %K. In fact, it will be double smoothed. Such an effect allows you to filter noise and reduce the number of fake signals, but it also increases the stochastic oscillator's lag. That's why it's called slow.
If you don't want to use smoothing, you should use 1 as the last parameter. Such stochastic indicators are called fast.
The full version of the stochastic oscillator allows you to change all three parameters and even how %D stochastic is smoothed.
LiteFinance gives you the chance to experiment with a free demo account, but also provides the full version of the indicator. But if I could, I would call it Super Full Platform provides such comprehensive settings.
LiteFinance supports four types of smoothing the stochastic oscillator:
Simple is classic smoothing and uses a simple moving average (SMA);
Exponential smooths using an exponential moving average (EMA);
Linear Weighted smooths using Linear Weighted Moving Average (LWMA);
Smoothed is double smoothing due to the feature of the Smoothed MA (Smoothed MA).
Such functions allow the user to make use of the stochastic oscillator formula in any trading tool and market, in order to spot easily the highest and lowest prices of the market when trading cfds, currency pairs, etc. There are no strict rules on what smooth settings to use with this momentum indicator, but it's vital to consider their differences for successful trading experiments.
Let’s visually compare how they differ.
In the case we trade forex, like the price chart above, the numbers can correspond to five signals of the stochastic oscillator.
It's clear that the second and fourth signals are fake. The first and fifth ones reflect the local correction. The most valuable signal is the third one, which indicates a trend reversal, in some points protects the trader from losing money rapidly.
Note! Here, the signals are a cross of %K and %D lines above 80% and below 20%. Later, we will talk about momentum indicator signals in detail. Now, it should be remembered as a condition for the experiment.
On the chart above, the stochastic oscillator takes various forms such as:
Slow with an SMA;
Slow with an EMA;
Slow with an LWMA;
Slow with a Smoothed MA.
Periods for all stochastics are similar: %K – 5, %D – 3. A smoothing period for all types except fast stochastic is 3.
A fast stochastic oscillator is a momentum indicator that reacts to the market movements faster than other types. It operates almost without a delay, but the number of fake signals is large leading investors on losing money rapidly.
Using a slow stochastic oscillator with SMA and LWMA is almost identical regarding the lag and number of fake signals.
The filter of the slow stochastic indicator with Smoothed MA was too strong and suppressed almost all signals. It provided only the last alert out of five.
The most effective slow stochastic was the one with smoothing EMA. This indicator successfully filtered fake signals and was slightly faster compared to its counterparts.
We tested the signals on the M30 chart of the EURUSD pair. Still, results may vary on other timeframes and trading instruments. You can compare any type of stochastic indicator using a free demo account right now on LiteFinance in several clicks without registering.
Timeframes also play an important role. The best stochastic oscillator settings for М5, М15, М30, and, sometimes, H1 timeframes are (10,7,3), (7, 3, 3), or (5, 3, 3). On high timeframes, such parameters may generate false signals. Therefore, stochastic oscillator settings for H4, D1, and, sometimes, H1 charts are (9, 3, 3), (14, 3, 3) or (21, 3, 3).
You can use slower curves with (21, 7, 7) or (21, 14, 14) settings for daily and weekly charts. The described setting combinations are used most often. You can practice and pick up your own parameters. Maybe you will succeed and find a perfect combination for your stochastic strategy.
The crossover between the %К and %D curves is the leading signal of the stochastic oscillator tool. It's analyzed only in overbought and oversold zones analyzing the current closing price. In other cases, such signs are useless.
There are two types of crossovers:
When the %K line curve breaks above the %D line, the trend is bullish. In this case, it's worth placing a pending order slightly above the cross point.
When the %K curve crosses the %D line upside-down, strong sell signals are monitored meaning that a bearish trend begins. A short position should be open slightly below the breakout point.
Below I will show how to use the stochastic oscillator by spotting the overbought and oversold conditions on the EURUSD chart.
Above the green oval, you can see an upward cross of %K and %D lines. Since the signal occurred below 20%, the risk of it being false is low. Here, it's worth opening a long trade near the highest point of the crossover candlestick. On the chart above where the lowest prices are, I marked the entry level with a green line.
Here, we observe the opposite situation. A %K line curve crosses the %D one downwards at a price range, slightly above 80%. Therefore, analyzing the behavior of the stochastic lines, we can open a short position near the close price of the candlestick where the cross happened.
At the same time, a small shift down is acceptable. In the chart above, this situation is marked with a red oval.
Overbought & Oversold
The stochastic oscillator can help the user to have a better understanding of the overbought and oversold conditions of the market. The overbought issue occurs within an uptrend when the main line crosses the 80% level in an upward direction. It's a sign that the rise slows down, and the price trend reverses down. Generally, a sell position should be open when the line breaks the 80% level back from the top, where the last closing price is, and follows the downward direction.
Oversold conditions happen in the downtrend when the line falls below the 20% level. In a similar fashion, it signals a slowdown of the price decline and that there is about to be a reversal. It's recommended to buy when the curve exits the oversold area crossing the 20% line bottom-up.
When analyzing the indicator's behavior in overbought or oversold zones, it's worth considering the reversal's formation in order to spot a potential buy or sell signal. If the primary curve forms an acute angle, the following price movement will be intense. If the repeated break occurs after flat conditions, the move will likely be weaker but stable.
Using the stochastic oscillator on the chart, blue squares indicate overbought areas; red ones mark oversold zones. In all three cases, those major signals show that the price tends finally to be reversed. The right blue square displays a sharp turn. It corresponds with the area on the graph marked with a blue oval. After the reversal, there is an intensive downward movement showing a potential sell signal, offering to the trader the chance to understand how spread bets.
Bull & Bear Divergences
When applying the stochastic oscillator on a chart, divergence occurs rarely, but its signals are highly accurate.
Bearish divergence: When a price tend hits maximums, but the stochastic lines of %K and %D can't overcome the previously highest prices(marked with the blue line) on the overbought or oversold region, it means there will likely be a reversal in the downward direction soon and works as a sell signal. Thus, we can open a short position after the indicator's moving averages cross and the signal candlestick closes. In that situation a bearish divergence occurs.
When the market price falls, but %К and %D curves don't reach previous lowest prices (marked with red lines), it's a sign of the upward reversal. We can open a buy trade after the cross and closure of the signal candlestick. When this phenomenon we say that a bullish divergence occurs.
A rough change that occurs either on the overbought or oversold levels is known as stochastic divergence. Entry signals are marked with black circles.
Based on the text above, you can recognize the bearish divergence from a bullish divergence, in the overbought or oversold region. If you aren't sure yet, you should read the article “What the divergence on Forex is” where the issue is explained in detail.
Ignore the fact that there is a different indicator in the article. The stochastic oscillator follows the classic rules of the technical analysis for bullish and bearish divergence and convergence. Everything you read in this article will work for the stochastic in order to monitor efficiently the price movement of our asset as well as to have a better understanding of when a bullish or bearish divergence occurs.
Bull & Bear Set-ups
Bullish and bearish patterns look the same as the stochastic divergences we covered above, but they provide different signals:
A bullish pattern is adjusted when the new highest price forms a lower-than-previous high, but the stochastic has a higher high than the last closing price. It leads to a short-term price trend decline and a reversal. So, this pattern should be used as a bullish entry point ahead of the upcoming rise.
A bearish pattern occurs when the new lowest price has higher lows, but the oscillator forms a lower minimum, indicating strong sell signals. Such types of price movement can be considered false signals since, later, the price will rebound and reverse.
Circles and violet lines mark local minimums on the price chart and the stochastic indicator. This means the formation of a bullish pattern that outruns the reversal signal. There is a short-term price decline (red area) where a trader can monitor how the spread bets, a price reversal, and a new bullish trend (green area).
Real Examples of Using Stochastic Indicator in Forex Trading
Stochastic is a technical indicator that provides a vast number of different signals. It can be applied to different trading methods: scalping, intraday, swing trading, etc. Below, we’ll provide more information about using the stochastic oscillator in different timeframes.
First, let’s look at how to add and set stochastic oscillator best settings for intraday timeframes.
To implement the technical indicator in the chart, press “Indicators” and choose “Stochastic Oscillator” from the dropdown list.
Most importantly, let's define the leading trend of the price movement. We will do it using the stochastic with 21, 7, and 7 parameters.
It's essential to determine the technical indicator's direction and its location in the area above or below 50%. In our case, the blue main %K line is in the chart's upper zone and is moving down (the green oval). Therefore, the downward movement is dominant.
The intraday trading occurs on timeframes that are not bigger than H1. For example, we will take the M30 one. The perfect settings for such a timeframe are 5, 3, and 3.
As the primary movement is downward, during the day, we will look for a trading range when lines enter the overbought zone and %K crosses %D from the bottom up. One such case is marked with a green oval, showing the price range of our asset. Note, curves stay in the overbought area for a long time. That's why the upcoming downward movement is supposed to be stable, and a strong sell signal is expected.
The next step is to identify the last closing price on a reversal pattern. An example of such a setup is depicted above as Doji. Still, there can be any other reversal combination of a classic candlestick analysis and Price Action.
Usually, it appears near the cross of the %K and %D curves. On the chart, this pattern is marked with a blue oval. When one of the following candles crosses a low point of the pattern, open a sell position at the price of 1.18329 (blue line on the chart). The stop-loss is placed slightly above the highest price (maximum point) of the reversal pattern (red line), and the take profit should equal two stop-losses.
When monitoring a trading range like the above, we can spot an alternative option to define the take profit level. When the market price falls, relocate the stop-loss to a breakeven zone. Touching or crossing the 20% level will be a signal to close a position. In our case, such a situation is marked with a red oval.
You can fix your profit when the candlestick closes on the breakdown of the 20% line (green line) on the price of 1.17971.
As a result, we get the profit of 0.00358 points (1.18329 – 1.17971 = 0.00358).
For the scalping strategy, we will use a 5-minute timeframe and the stochastic settings:
- Period %K – 10;
- Period %D – 7;
- Length – 3.
Big trading range periods for such a timeframe will be compensated by changing the limits to 30 and 70. You can change these parameters in the “Style” tab of the indicator's settings.
We will buy if the following conditions are met:
- Lines are on the border of 30% or beyond;
- %K crosses %D from the bottom.
Conditions for a sell trade:
- Lines are on the border of 70% or beyond;
- %K crosses %D from the top.
Stop loss is set at the extreme of the local minimum of 3-5 previous candles. The take profit is placed at a distance of the stop-loss or more in 5-10 points. It is recommended to trade with small fixed lots.
The blue circle points at the cross of the %K and %D lines upside-down above the 70% level. We open a sell position at the close of the candlestick (the blue line). The stop loss is placed at the local maximum (the red dotted line), and the take profit is almost at the same distance (the green line).
As we can see from the chart, the trade was successfully closed at the take profit level. To open a buy trade, the steps are similar.
On the chart above, there is an example of the scalping strategy for a long trading range. As we can see, the price hasn't reached the take profit level but turned around. You should be ready for such situations as sometimes stochastic indicators provide fake signals when trading cfds, pairs, etc. Profit is gained due to narrow stop-losses and plenty of trades, but most of them should be profitable.
To understand the stochastic swing strategy, we should learn the “Star” pattern. There are two types.
The “Morning Star” consists of three consecutive bars:
- The first one is bearish with a long body;
- The second one forms with a gap (ideally) with a bottom shadow and a short body;
- The third one is bullish with a long green body that overcomes the most significant part of the first candle's body.
The opposite is the “Evening Star.” It includes three bars:
- The first one is bullish with a long green body;
- The second one has a short body and a gap up (ideally);
- The third one is with a bearish long red body covering the most significant part of the first candlestick.
To be completely honest, the ideal version of the pattern occurs rarely. But it's vital for the one in the middle to have a long shadow in the direction of the completing trend, and for the next candle to have a long body.
At the same time, the longer the body, the more reliable the signal is. In an ideal scenario, it should cover several previous candles. In the picture above, you can see an example of the shooting star that doesn't correspond to all the rules but provides a strong sell signal when trading cfds, stocks, or other types of assets.
We will use the best stochastic settings for swing trading. These are 5, 3, and 3, which provide sufficient signal density.
Conditions for a long position:
- Stochastic is below the 20 level;
- There is a morning star pattern at the reversal;
- The market starts moving upward.
Conditions for a short position:
- Stochastic is above the 80 level;
- There is a shooting star pattern at a reversal;
- The market starts moving down.
We should open a trade as soon as the bar after the pattern crosses its extreme in the trend direction. The stop-loss is set at the maximum point of the “Star”. We will close the position as soon as there is a cross of stochastic lines either above 80% or below 20%.
On the chart, you can see the shooting star's formation with the simultaneous crossing of the indicator lines in the overbought zone (the blue circle).
To make it more transparent, look at the zoomed-in picture of the pattern above.
We opened a trade at 1.37637, when the bar crossed the pattern's minimum point (the blue line). A signal to exit the market was a curve cross marked with the red circle. We fixed the profit at 1.34695, the close of the candlestick. The final profit was 2942 points (1.37637 – 1.34695 = .02942).
If you want to find out more about swing trading, I recommend reading the «Swing Trading» article.
Using a Stochastic Oscillator When Trading S&P 500 and U.S. Dollar
Each instrument shows its own behavior. It's crucial to consider it when trading. Below, we’ll look at stochastic trading features on the S&P 500 futures, gold, and the U.S. dollar.
S&P 500 Trading
Looking at this instrument's historical price movements, it's visible that the price decline doesn't always follow a stochastic move to the overbought area. Vice versa, when the indicator is in the oversold zone, it's more likely the market will rise soon.
The signals of a bullish reversal work well when the market is temporarily oversold in the uptrend. Signs of a bullish correction will likely work if the market entered an overbought area in the downtrend.
When trading gold, it's not recommended to use overbought/oversold signals even with a line crossing.
When the market is temporarily oversold in the uptrend, signals on a bullish reversal usually don't work. Meanwhile, it's likely a bearish reversal works when the market is temporarily overbought in a downtrend.
U.S. Dollar Trading
The U.S. dollar often continues moving following the momentum when curves enter overbought or oversold zones. Therefore, you should enter the market when there is a price reversal. The stochastic Forex strategy isn't useful for USD if it's based on fixing overbought conditions during an uptrend and oversold ones during a downtrend.
Combining a Stochastic Oscillator With Other Indicators
The stochastic oscillator is a high-frequency indicator that can generate false signals, especially in strong directional movements. It makes sense to use the oscillator with other trend indicators. Let's consider the most popular combinations using any type of stochastic oscillator with other tools, such as the stochastic RSI.
This is one of the simplest trend strategies that allow traders to get good results. To define a long-term trend, we will use the daily timeframe, while entry and exit points will be determined on the hourly one.
First, we add three exponential moving averages with periods of 50-, 100-, and 200-bars.
We use a stochastic oscillator to find the entry levels. The recommended settings are:
- Periods: 14, 3, and 3;
- Levels: 90% and 10%.
Conditions for a long trade:
- There is a long-term upward trend on the daily chart; the price moves up and is above the EMA (50), while the EMA (50) is above EMA (100), which, in turn, is above EMA (200).
- On the hourly chart, the oscillator crosses 10%.
Conditions for a short trade:
- There is a long-term downward trend on the daily chart; the price moves down and is below the EMA (50), while the EMA (50) is below EMA (100). And EMA (100) is below EMA (200).
- On the hourly chart, the oscillator crosses 90%.
Place the stop-loss slightly below the local extreme. Profit can be fixed by a take profit that is two times bigger than the stop-loss or by a trailing stop of EMA (50). If the most recent closing price is below it, you should fix profit.
In another version of the stochastic strategy on Forex, you should wait for the stochastic to enter overbought or oversold areas to fix profit. To make it clear, look at the example below.
We observe a long-term uptrend on the daily chart. Therefore, we will only open long trades while we monitor the most recent closing price.
With the hourly time frame, we wait until the curves cross 10% (the blue circle).
We enter the market at the close of the breakout bar where the lowest price is located (the blue line). A stop-loss is placed slightly below the minimum (the red line).
During the price movement, the stop-loss first moves to the breakeven and then to the profitable zone. We close the trade when the stochastic indicator comes closer to the 90% line where we compare it with the most recent closing price(the green line).
All trend strategies are used to open positions in the current trend or fix profit when the trend changes. Still, an entry point is considered a weak spot. A stochastic oscillator can solve this issue. A combination of a stochastic oscillator with any trend indicator can provide good results and avoid false signals.
In this regard, it's essential to follow several rules:
- Determine a trend on high timeframes;
- Don't open trades against the trend;
- Use a %K and %D cross in the overbought/oversold areas to define an entry point.
Try to use a stochastic oscillator with your favorite trend indicator. Follow these three simple rules, and you will be surprised by the result.
The Bollinger Bands indicator is the leading tool in this strategy, while the stochastic oscillator will be used as a signal filter. You can read more about them in my article “Bollinger Bands Indicator in Forex”.
Note! This strategy is intra-channel. The trade occurs within Bollinger Bands. The indicator settings are standard: the moving average period is 20 candles, and the standard deviation multiplier is 2.
We should also add a stochastic oscillator with 5, 3, and 3 parameters.
Conditions for a buy trade:
- A bar crosses (or at least touches) the bottom line of the Bollinger Bands;
- The %K line crosses the %D line bottom-up below 20%.
We can enter the market at the opening of the next candle after the signaling one.
Conditions for a sell trade:
- A bar crosses or at least touches the upper boundary of the Bollinger Bands;
- The %K line crosses the %D line upside-down above 80%.
Enter the market at an opening of the candle that follows the signal one.
A stop-loss is set with a small shift from the extreme point of the breakout bar. The ideal take profit level is at the opposite band of the Bollinger indicator. When working with a buy trade, it should be placed at the upper boundary, during a sell trade – at the bottom band.
Let's take a look at the strategy of Bollinger bands and stochastic oscillators through an example.
The blue circle points to the moment when the bar touches the bottom line. In the same area, the %K crosses %D from the bottom, thus, confirming the primary signal.
We enter the market at the opening of the next candle (the blue line) at 1.17444. The stop-loss is set slightly below the minimum of the touch candle, and the take profit is at the upper boundary – 1.17808.
In a while, the price declines, almost touching the stop-loss level, but it turns around and surges. The trade is closed at the take profit level (the red circle). The final profit is 364 points (1.17808 – 1.17444 = .00364).
Pros & Cons of the Stochastic Indicator
Easy to use and set
Fake signals, especially if the settings are wrong
Numerous signals: overbought/oversold, bearish or bullish divergence, and patterns
The high accuracy can be reached only when combined with other tools
Useful in any timeframe and for any trading asset to locate its highest and lowest price.
Plenty of trading strategies
Available for combining with other instruments of the technical analysis
Widely used. The indicator is available on any platform for technical analysis.
Stochastic Oscillator vs. RSI
The stochastic oscillator and the relative strength index (RSI) are often compared. This is partly due to the fact that are both among the most popular technical analysis tools. Professional traders widely use both indicators. Still, besides their popularity, they have many other similarities:
They are oscillators.
They reflect the speed of the price change.
They provide the same signals: overbought/oversold zones, bearish and bullish divergence/convergence.
They are flexible: useful on any timeframe and for any market.
Meanwhile, they have many differences:
Settings. The RSI has only one setting; it's a period of the moving average. The stochastic has four parameters.
There are unique signals. Traders widely use a cross of the stochastic oscillator’s %K and %D curves. The RSI doesn't have a smoothing moving average. However, the relative strength index is used to set support and resistance levels. We can apply graphical analysis for this indicator.
Standard overbought/oversold levels for stochastic are 80/20; for the RSI, 70/30.
I would not advise beginner traders to combine the RSI and stochastic oscillator. Both tools are based on the measure of price dynamics. That's why signals won't vary a lot. If using them together, they will likely confuse you due to the high frequency of alerts and fake signals.
Nevertheless, we can't compare the stochastic and the RSI. Each of them is unique and valuable for traders.
If you want to learn more about the relative strength index (RSI) and related trading systems, I recommend reading this article.
Stochastic Oscillator FAQ
Three main parameters set the oscillator. The period of %K line defines the range that the indicator will use to compare the current price. The %D line period determines the smoothing of the %K curve to get the slow stochastic.
The slowdown smoothes the major period of the %K line, thus, affecting it. For short timeframes (including H1), the standard settings are (5, 3, 3) or (7, 3, 3). (9, 3, 3), (14, 3, 3) and (21, 3, 3) settings are useful on H4, daily, and bigger timeframes.
It depends on the selected trading strategy.
Both indicators help determine when the asset is overbought and oversold as well as where its highest and lowest price is located. Both tools, even with ideal settings, provide false signals.
Both usually work in combination with other tools. They are included in the classic technical analysis and remain popular among plenty of traders.
Stochastic oscillators and RSI have benefits and limitations. Choose the indicator according to your trading strategy.
Stochastic Oscillator Conclusions
There are no 100% accurate instruments of technical analysis. The stochastic indicator confirms this. It provides plenty of signals, but some of them are false.
You can minimize this limitation using two methods:
- Find practical settings for the trading instrument and the timeframe;
- Filter stochastic signals with other tools of the technical analysis.
Reversal candlestick patterns and chart patterns, such as triangles and “Head and Shoulders,” are the best for signal confirmation. It's highly recommended to implement the stochastic oscillator with other trend indicators. It helps avoid numerous fake signals. Take time to learn more about the trading strategy of stochastic with Bollinger Bands.
The stochastic oscillator is an excellent tool due to the number of adjustable parameters and the simplicity of the supplied signals. So, you should practice it to get high-quality trading alerts and locate the highest and lowest price in order to compare. Despite how long ago it was invented, the stochastic oscillator is a perfect supplement of any strategy today.
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