4.27 How to Use Stochastic Oscillator

Stochastic oscillator. 


A stochastic is a great technical analysis oscillator that shows us if a pair is in the oversold or overbought zone.


So, if the world and their wives (sorry ladies, for you we'll say the world and their husbands) have already bought in to the pair, it could mean that the pair is overbought – a sign that the uptrend could be nearing its end. You don’t want to enter a buy trade here, instead, if you are already long, look out for when to cash in the chips. Similarly, if the pair is oversold, get ready to cover your shorts and go for buying. 


But first, look at the Stochastic. Here, on this chart, let us show you what it does.


Stochastic oscillator on a Forex chart. 


See the pair of lines in the lower panel? That is the stochastic – a slow one and a faster one. For time being never mind about their slowness or fastness – what’s really important is where the lines are now in relation to the two horizontal lines – the lower one marked 20 and the upper one labeled 80. The extreme limits for stochastic oscillator are 0 and 100 and this indicator is supposed to oscillate in this range. However, the ranges of 0 to 20 and 80 to 100 are the important ones to watch for. The former defines the oversold and hence buy zone and the later, the overbought i.e.  the “sell” zone.


Trading with Stochastic Oscillator


Trading based on Overbought and Oversold situations


The area under the 20 line is an oversold zone and that above the 80 line is overbought - sort of like the speedometer on your car and the red band after 100mph – dangerous territory!


Look at the chart and the arrows in the lower, oscillator panel and in the upper, price panel. See how the prices moved down after the oscillator touched 80 and above, and how they moved up from the lower horizontal level.


Nice moves to have picked up some pips trading both sides of the market. But here’s a word of caution – sometimes prices may hang around the OB or OS zones for a while. We mean, don’t always expect immediate reversals from these zones. In the chart below, see how long prices stayed in the overbought zone before reversing to the downside. 


Stochastic oscillator during strong trends.


So it's always better to look out for some signs which indicate possible reversals. These signs can be as follows:


  1. Bullish divergence in stochastic oscillator when it is in oversold zone for a long position.

  3. Bearish divergence when stochastic oscillator is in overbought zone for a short position.

  5. Any resistance levels or resistance trend lines emerging in overbought zone. Similarly any support zones or support trend-lines coming into picture in oversold zone.

  7. Any bearish or bullish signals by other indicators like MACD, moving averages or Ichimoku cloud etc. 

  9. Crossover signals by stochastic indicator itself, as explained later.


So always try to double check the possibilities of breakouts before jumping in to take a position based on overbought or oversold situations.


Trading Based on the crossover signals


Stochastic oscillator consists of two lines. The main line (called %K line) and the trigger line (called %D line). The crossover trading signals are generated when the main line crosses the trigger line upwards or downwards. 


When the main line (%K line) moves below the trigger-line (%D line) a bearish signal is generated and when the main line moves above the trigger line, it’s a signal to go long.


Calculation and Construction of Fast Stochastic


In fact you really do not need to go into the details of the calculations and construction of stochastic oscillator but just in case you are curious, let’s see how stochastic is calculated and what are %K and %D. Secondly, you may be wondering what the heck is this "FAST Stochastic" which we mentioned in this heading.


Don't worry, as far as usage of stochastic oscillator is concerned, everything we mentioned above stands true whether it is fast or slow. However, let us tell you that this oscillator comes in three colors, or shall we say three shades or color? Well, the formulas to calculate these three versions are slightly different. Here, we talk about the Fast Stochastic. The other two versions were developed to contain the number of false signals which the faster version may tend to generate.


The most common setting for Stochastic oscillator is 14 periods. Let's say we are considering daily chart then 1 period would mean 1 day. And let's say that the price action for the previous 14 days was as follows:


Time Period High -during the period Low- during the period Closing of the period
1 155.40 152.00 155.21
2 155.83 152.00 152.66
3 154.32 147.80 149.45
4 150.10 146.10 147.45
5 148.92 145.73 148.14
6 149.34 145.14 146.00
7 151.92 146.23 149.10
8 153.40 150.06 153.10
9 154.32 150.72 151.61
10 152.85 149.14 150.21
11 155.08 152.15 154.81
12 155.60 153.00 153.41
13 155.12 152.85 155.12
14 155.45 150.76 151.41


In the above example the most recent closing is 151.41, the lowest during the 14 days was 145.14 and the highest during the past 14 days was 155.83.


The following formulas show how %K and %D are calculated:


%K = 100*[{Current Close (n) - Lowest (n)} / {Highest Price (n) - Lowest (n)}]

Here "n" is the selected number of periods. On a daily chart it would mean 14 days and on an hourly chart it would be 14 hours.


%D = 3 Period Moving Average of %K


Hence considering the price table above:

%K = 100 * [{151.41-145.14}/{155.83 - 145.14}] = 58.65%


Summary of %K and %D:


  • %K indicates the relative position of current closing with reference to the highest and lowest prices of the selected period of time.

  • The %D line is drawn by connecting the SMA (Simple Moving Average) points of the relative position i.e. %K for previous 3 periods.


Hence what we are checking is where the current relative position i.e. %K stands against it's own moving average of past 3 days i.e. %D.


Let's move on to the other two versions of stochastic. Be with us... 


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