Stochastic Oscillator was developed by George C. Lane in the late 1950s. This is a momentum indicator and used quite commonly for technical analysis. Please read to see the concepts behind this indicator, how to use it in making trading decisions and trading strategies using this indicator. Please note that the explanation if focused for Forex trading but it is equally valid for stocks or any commodity trading.
In a dynamically changing market won’t it help if we know where do we stand currently with reference to past price movements? Stochastic oscillator helps us there. It compares the current value with the highest and lowest points during the selected time period. For example if we select a time period of 2 weeks then this indicator will check the current price, the highest level during past 2 weeks and the lowest level during the past 2 weeks and would give indicate where the current price is, in relation to the highest and lowest of the selected time period i.e. 2 weeks in this example.
Why knowing the current value in relation to the highest and lowest of the selected time period is important for trading Decisions?:
Its important to know the current market sentiment/trend in trading. What we mean is whether the market sentiment is towards buying or towards selling. Suppose we are analyzing the movement data for past 2 weeks and if the current closing* levels are consistently near the highest values of past two weeks, it would indicate that people are still buying and the further upward move may take place. Opposite to this If the current closing levels are consistently near the lowest level of past two weeks, it would indicate that traders are either not buying or they are in the selling mode, and hence the market has negative sentiment for the pair concerned. But only this observation is not conclusive. Stochastic indicator will also indicate about any recent change in the trend. Suppose the recent price is close to the lowest of during the considered period but recently it has started moving up, this would signal that an uptrend may be taking place.
The Stochastic oscillator has two lines. The main line (called %K) and a trigger line (called %D). The main trading signals are generated when the main line crosses the trigger line upwards or downwards. Trading signals are also generated by over bought & over sold situations and divergences which are explained later.
* please refer Candlestick Charts page for the explanation about the opening, closing, high and low of any given period.
How this indicator looks in the trading platform chart:
Let’s see how Stochastic is calculated and what are %K and %D.
The most common setting for Stochastic oscillator is 14 periods. Let's say we are considering daily chart and hence 1 period means 1 day. Let's say the movement for previous 14 days has been as follows:
|Time Period||High -during the period||Low- during the period||Closing of the period|
Here the most recent closing is 151.41, the lowest during the 14 days was 145.14 and the highest during the 14 days was 155.83.
Now let's see what %K and %D are and how those are calculated:
|%k||100 X (||Current Close (n) - Lowest (n)||)|
|Highest Price (n) - Lowest (n)|
Here (n) is the selected number of periods used e.g. 14 periods on Daily chart would mean analysis for 14 days. On hourly chart it would mean analysis for 14 hours.
|%D||3 Period Moving Average of %K|
Hence considering the price table above % K would be:
|%k||100 X (||151.41-145.14||) = 58.65%|
|155.83 - 145.14|
%K shows the relative position of current closing with reference to the highest and lowest of the selected period
The %D line is SMA (Simple Moving Average) of the %K for previous 3 periods.
So what we are checking is how the current relative position (%K) stands against the 3 day moving average of the same i.e. %K. That is the relative position of the “current” %K against its own average for past 3 periods’ data. If the current price is near the highest but started going below the average of itself during past 3 periods, the market may further go down. Please note that if we are working on daily chart then 1 period = 1 day. If we are working on hourly chart then 1 period = 1 hour.
Let's take my favorite driving example for a simpler explanation of Stochastic.
For example, let’s say we have been driving for past 14 hours. During the driving the speed is continuously changing. Let's say that main factor which is causing the change of speed is road conditions. There are places where there are long bad patches and then slowly the road condition improves for some kilometers and so on. Well, depending on the road condition the speed goes up or down.
Let’s say our speed data has been as follows:
1) Highest (fastest) speed during the past 14 hours : 140 km/hr (German Autobahn lovers (like me), please excuse me… you may consider 250 instead of 120 :-)
2) Lowest (slowest) speed during the past 14 hours: 40 km/hr.
3) Current speed: 60 km/hr.
Now % K (using the formula mentioned above): 20% which is very close to the lowest level (above 50% will be closer to the high speed during the period i.e. past 14 hours). We are uncertain whether the road condition will worsen and speed may further go down or the road conditions have started getting better after a very rough patch and the speed may further improve from now onwards.
Let’s see this example in tabular form:
|Time||Closing speed at the end of the hour (km/hr)||%K||%D||Remarks|
|1:00 PM to 2:00 PM||42||11%||13.00%||%K is less than its average during past 3 hours. Not doing better what it was doing during past 3 hours. May go down further|
|2:00 PM to 3:00 PM||42||12%||13.00%||%K is less than its average during past 3 hours. Not doing better what it was doing during past 3 hours. May go down further|
|3:00 PM to 4:00 PM||45||14%||15.30%||%K is less than its average during past 3 hours. Not doing better what it was doing during past 3 hours. May go down further|
|4:00 PM to 5:00 PM||60||20%||16.30%||%K is more than its average during past 3 hours. Doing better than what it was doing during past 3 hours. Road conditions seem to start improving. Speed may further increase.|
During the current hour the % K (%K represents the current status as compared to the lowest and highest levels) started going higher and crossed %D (%D represents the recent past of %K) and became current 20%. What does it tell us is that though we are still very slow but recently the speed has started increasing… the road conditions may be improving and may further improve to have faster speed. It may be the “Buying Time”.
There are 3 different types Stochastic oscillator. These types came into existence in order to optimize the balance in number or frequency of signal generation and good signals.
If an indicator generates too many signals at very high frequency then the chances are that percentage of false signals may be high. The different types were developed as an improvement of the original indicator to avoid more false signals.
Please check about Slow Stochastic and Full Stochastic and the differences of these three types.
Types of trading signals:
Stochastic indicator is an oscillator. It moves between “0” and “100”.
Readings below 20 are considered oversold (indicating that it may be the time to buy as people may start buying now and hence there may be further upward move) and readings above 80 are considered overbought (indicating that it may be the time to short sell as there may be further downward move).
However, level above 80 does not necessarily indicate that people will not buy further and a reading below 20 cannot conclude that people will not sell further. The market may continue to rise after the Stochastic Oscillator has reached 80 or crossed over 80 and continue to fall after the Stochastic main line has reached 20 or gone below 20.
Summary: The 80 & 20 only indicate that the reversal would come but cannot indicate the time when it will happen. The bullish sentiment (uptrend) can continue time even after the Stochastic is over 80 and similarly the downtrend can continue after the it below 20. Hence taking action only on the basis that it has crossed above 80 and hence prices would come down or Stochastic has crossed below 20 and hence market would start going up may take us for a ride on the wrong side of the road. Avoid this reading in isolation as a signal.
Buy and sell trading signals can are also generated when %K crosses above or below %D.
When %K line crosses the %D line (trigger line) from below to above, it signals that the market is moving up and may move up further. It gives us a “Buy” signal. Please note that the “Buy” signal by crossover is more authentic when the Stochastic is near or below 20 (over sold area). Avoid using this “Buy” signal when it is near 80 or above 80 (overbought area).
When %K line crosses the %D line (trigger line) from above to downwards, it signals that the market is moving down and may move down further. It gives us a “Sell” signal. Please note that that the “Sell” signal by crossover is more authentic when the Stochastic is near or above 80 (overbought area). Avoid using this “Sell” signal when it is near 20 or below 20 (overbought area).
However, crossover trading signals are quite frequent and can result in a lot of false signals. The better results would be when the crossover takes place when the Stochastic main line moves from overbought territory back below 80 and from oversold territory back above 20.
In the above Forex chart:
Point A: The %K is above 80 i.e. in the overbought region. Overbought region just tells us that the currency is overbought and people may start selling and hence the market may start falling. As mentioned earlier that %K reaching overbought region should not be taken as signal because in a strong uptrend the buying can continue we can in the overbought region for long time.
At point “A” %K was in overbought region but then crossed %D line from above to below. The price at point “A” was approx 1.5800 (1 EUR = 1.5800 USD). The market went up but then subsequently went down to close to 1.5600. A profit of close to 200 pips if we short sold at the crossover at point “A”. It is always advisable to put a limit buy or sell order at few pips below or above respectively when the cross over takes place. It is to take care of the frequent correction in the opposite direction of the movement. It adds pips to the profit than if we tend to buy or sell at the crossover point.
Point X (corresponding value approx 1.5700):
Stochastic was near 40 i.e. closer to oversold region (oversold region is below 20). At point X the %K line crossed %D line from below and moved up. This signals an upward movement and that’s what exactly happened. The market moved up approximately 100 pips i.e. from close to 1.5800 to near 1.5900.
Point B: %K line crossed %D line from above to downwards. A signal that there may be a fall. there was a fall but not substantial.
Next crossover at unnamed point after point B: The %K line crossed %D upwards. This signals that price may go up but this proved to be a false signal. A very important point to be noted here is that the Stochastic was around 60 and hence was neither in the oversold nor in the overbought region. The best crossover signals are as follows:
If the crossover takes place when Stochastic is in the middle i.e. neither in oversold nor over bough region, please avoid taking an action immediately at the crossover. Wait a little to see if the movement is really taking place in the direction indicated by the signal.
Point C: %K crossed %D from up to downwards. Even though the Stochastic main line was not in overbought region there was a strong fall.
The very important point to be noted here is divergence shown by point A, B and C. Divergences may prove to be the best trading signals and will be explained under the next heading.
For the most reliable trading signal, wait for a divergence to develop from overbought or oversold levels. Once the oscillator reaches overbought levels, wait for a negative divergence to develop and then a cross below 80. It's better not to sell at the first dip below 80 but wait to see if it bounces back over 80 again. Most of the time it would bounce back over 80 after the first dip. The second dip results in the sell signal. For a buy signal, wait for a positive divergence to develop after the indicator moves below 20. It is better to disregard the first break above 20. After the positive divergence forms, the second break above 20 confirms the divergence and a buy trading signal is given.
In the above shown chart, point A was a peak in the overbought region. The main line went down after point A and then climbed again before going down from Point B. The peak at point B was lower than point A. next peak at point C was lower than peak at Point B. And see what happened. When the %K line crossed %D line downwards near point C, the market fell real heavily.
Take a note of such divergences when the subsequent high or low points (peaks and valleys) are going lower than the previous peaks. It may give a good signal for an emerging down trend. Similarly if the subsequent high and low points (peaks and valleys) are going higher than the previous ones, it may give a good signal for an emerging uptrend.
In the Forex chart shown above, please note that from the crossover at point P, the price moved higher as the signal suggested. Point Q was practically a false signal because the crossover took place neither in over bought nor in oversold region. Crossover at point R signaled short selling as it indicated that the market may fall and there was a slight fall. Crossover at point S proved to be a very good signal. The price went up heavily. Note that the lowest point at S was higher than the previous lowest point at P. This was a case of divergence. Hence at point P we got two signals from stochastic oscillator, one from crossover and another by divergence.
Please study the forex chart below below and practice analyzing it based on all the explanations above to see how the trading signals worked.
Check Stochastic with ADX and Bollinger Bands
Stochastic with ADX, SAR, RSI and MACD
We explained Stochastic Oscillator in the context of "Forex Trading" but the same stands good for stock trading or any commodity trading.