Stochastic Oscillator Explained


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stochastic lines

If we apply the function to the closing price of the EURUSD hourly time frame with a 50 lookback period we will have the following chart. If the stochastic changes direction and leaves the overbought or oversold area, it could be signaling a reversal. Similarly, an instrument won’t automatically rise in price just because it is oversold. Overbought and oversold simply mean the price is trading near the top or bottom of the range.

moving averages

Charts tend to stay within the 20/80 readings during range bound markets but break above or below during strong trends. Traders widely use a cross of the stochastic oscillator’s %K and %D curves. However, the relative strength index is used to set support and resistance levels. Ignore the fact that there is a different indicator in the article.

An overbought level is an area where the market is perceived to be extremely bullish and is bound to consolidate. An oversold level is an area where market is perceived to be extremely bearish and is bound to bounce. Hence, the Stochastic Oscillator is a contrarian indicator that seeks to signal reactions of extreme movements.

This material does not consider your investment objectives, financial situation or needs and is not intended as recommendations appropriate for you. No representation or warranty is given as to the accuracy or completeness of the above information. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. Any research provided should be considered as promotional and was prepared in accordance with CFTC 1.71 and designed to promote the independence of investment research. If there is a reading over 80, the market would be considered overbought, while a reading under 20 would be considered oversold conditions. To use the stochastic oscillator, it is first important to understand exactly what the readings are showing you.

Like a rubber band that has been stretched and finally let go on one side, the price tends to snap back up with the stochastic 20-band crossover. On the flipside, an 80-band stochastic crossover down forms a sell/short-sell trigger. While the adjustment to 85/15 does reduce the number of false signals, it may lead to traders missing some trading opportunities. Rather than using readings above 80 as the demarcation line, they instead only interpret readings above 85 as indicating overbought conditions. On the bearish side, only readings of 15 and below are interpreted as signaling oversold conditions. The Stochastic Oscillator is an indicator that compares the most recent closing price of a security to the highest and lowest prices during a specified period of time.

When you find a regular, you should discount the Stochastic Oscillator crossover signal as it would often turn out to be a false signal. For example, in figure 4, the first few Stochastic Oscillator signals generated during the regular bullish divergence proved to be false. The last type of signal generated by the Stochastic Oscillator is called divergence signals. Stochastic Oscillator can generate both trend reversal and trend continuation divergence signals. The trend reversal signal is referred to as regular divergence signals, and the trend continuation signal is known as hidden divergence signals. The stochastic divergence signals tend to be the most powerful and reliable of all the different types of Stochastics generated signals.


The closer to 0 and 100 respectively, the closer to the low or high in the trading range. This change in momentum is demonstrated by the uptrend, although it is not difficult to see where the momentum is starting to fade above 80%. When the short-term trend line breaks through the SMA and falls under the 80% level, this indicates yet another change in trend – a potential sell signal. There are many ways in which you can use the stochastic oscillator indicator to open positions, close positions, or even reduce your position if the chart is at a critical point. tend to close near the extremes of the recent range just before turning points. In the case of an uptrend, prices tend to make higher highs, and the settlement price usually tends to be in the upper end of that time period’s trading range. Additionally, traders should not blindly trade based on overbought/oversold conditions alone. Traders need to understand the direction of the overall trend and filter trades accordingly. For example, when looking at the USD/SGD chart below, since the overall trend is down, traders should only look for short entry signals at overbought levels. Only when the trend reverses or a trading range is well-established, should traders look for long entries in oversold conditions.

The close less the lowest low equals 8, which is the numerator. The Stochastic Oscillator is above 50 when the close is in the upper half of the range and below 50 when the close is in the lower half. Low readings indicate that price is near its low for the given time period. High readings indicate that price is near its high for the given time period. The IBM example above shows three 14-day ranges with the closing price at the end of the period line. The Stochastic Oscillator equals 91 when the close was at the top of the range, 15 when it was near the bottom and 57 when it was in the middle of the range.

This shows less upward momentum that could foreshadow a bearish reversal. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.

If you search the internet, books, courses, and etc, they will tell you the best time to use the Stochastic indicator is in a range market. So, when you see the Stochastic crossing above 20, it’s telling you bullish momentum is stepping in . You’ll look for trading setup on the lower timeframe – to go short. You want to make sure the daily timeframe is not in a downtrend with Stochastic overbought. But it can help you anticipate where the pullback might end, so you can better time your entry and trade with the trend. As you can see, if you went short just because the market is overbought, it would have been a painful experience.

closing price

The 2 lines are similar to the MACD lines in the sense that one line is faster than the other. This simple momentum oscillator was created by George Lanein the late 1950s. Finally, I am a firm believer of not spoon-feeding the learners.

The stochastic oscillator and the relative strength index are both price momentum tools used to predict market trends. While often used in tandem, there are notable differences between the two indicators. One of the essential tools used for technical analysis in securities trading is the stochastic oscillator. Its primary incentive is to understand how strong the market’s momentum is. The K line is faster than the D line; the D line is the slower of the two. The investor needs to watch as the D line and the price of the issue begin to change and move into either the overbought or the oversold positions.

Stochastic Oscillator vs MACD

The point of using the Stochastic in this way is the momentum bounce, which is reflected with a unique Admiral Pivot set on hourly time frames. The Stochastic Oscillator is a great momentum indicator that can identify retracement in a superb way. Don’t forget the basic principle of trading – in an uptrend we buy when the price has dropped, and in a downtrend we sell when the price has rallied. This is exactly what the Stochastic is pinpointing – when the price is ready to be sold and/or bought.

It uses volatility rather than closing prices as a basis for calculation. RSI is available as a technical indicator on most stock screeners, including StocksToTrade. The Moving Average Convergence Divergence is a prominent momentum indicator, although it is very different from the stochastic oscillator indicator. You calculate the MACD by subtracting the 26-period exponential moving average from the 12-period exponential moving average.

Suppose during an uptrend, the oscillator reaches a high reading of 82, after which price turns to the downside. In that case, a trader may have missed the opportunity to sell at an ideal price point because the oscillator never reached its required overbought indication level of 85 or above. In a trend-following strategy, traders monitor the stochastic indicator to ensure it stays crossed in one direction. Typically, traders look to place a buy trade when an instrument is oversold. A sell signal is provoked once the oscillator reading goes above 80 and returns to readings below 80. In contrast, a buy signal is initiated when the oscillator shifts below 20 and then back above 20.

  • However, this would not allow for detecting stochastic crossovers, which requires both lines, also known as a “Full stochastic”.
  • You can confirm a bullish or bearish divergence with the support or resistance break.
  • The 80 and 20 levels, together with a stochastic setting of 14, 3, and 3, are the most popular setting for intraday trading to provide overbought and oversold signals.

Instead, should look to changes in the stochastic oscillator for clues about future trend shifts. The Stochastic Oscillator is a momentum indicator that measures the location of the closing price on a chart in relation to the high to low trading range over a period of time. This indicator was created by George C. Lane in the late 1950s. The Stochastic Oscillator isn’t following the trend in price or volume, what is quantifies is the speed and momentum of price action itself on the chart.

However, when it comes to overbought and oversold areas, there are differences. Stochastics measure the momentum, not the range of the price movement. This inconsistency is what turned off many followers of stochastic oscillators.

Stochastic indicator formula

Lane, a financial analyst, was one of the first researchers to publish research papers on the use of stochastics. He believed the indicator could be profitably used in conjunction with Fibonacci retracement cycles or with Elliot Wave theory. Indicator description, settings, entry, and exit conditions. What is the VWAP and how to use it in MT4 and other platforms?

price range

It shows the close relative to the high-low range across several periods. Many Forex traders have experimented with trading with the stochastic indicator. When used correctly, this indicator can help you better gauge price movements in both trending and range bound markets. This makes it easy to identify overbought and oversold signals.

How to Time your Entries

In the above chart, the red, dashed lines show the stochastic in an overbought position. Whenever the stochastic is within the overbought or oversold , don’t fight the trend but instead stick with it and hold on to your trade. When you see the stochastic accelerate in one direction with the two stochastic bands widening, it could be signaling the start of a new trend. From this, we can conclude that such traders mean that an oversold market has high chances of going down, and vice-versa. A pull-back is a short-term movement that goes in contrary to the existing direction of the price trend. Also, an oversold level should be considered as an indication of a strong trend, not a reverse signal.

When the price is below average and a downtrend occurs, you will have to wait for short entries on pullbacks occurring in the trend. If the market’s movement is above the simple market average, that is, in a bullish environment, you can enter long when a pullback occurs. No trader should follow the overbought or oversold rule blindly.

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