How to use the Stochastic Oscillator indicator?
What is a Stochastic Oscillator indicator? How to install and configure Stochastic Oscillator? How to trade on this indicator? What are the strategies using the Stochastic Oscillator indicator?
Welcome you friends! Today we’ll talk about such an important indicator of technical analysis used in most trading strategies like Stochastic Oscillator . Stochastic Oscillator is an indicator developed by George C. Lane in the late 1950s. This is an impulse indicator that measures the relationship between the closing price of a currency and its price range for your chosen time period. The Stochastic Oscillator indicator does not follow the price and volume, but monitors the momentum and speed of the price. This indicator helps determine overbought / oversold conditions in the market, and traders use them to generate buy and sell signals. Stochastic Oscillator changes direction before price makes it, making it a leading indicator in the market. And the bullish and bearish divergence, determined using this indicator, helps traders to identify significant reversals of the trend in the market.
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How to read the Stochastic Oscillator indicator
The stochastic oscillator ranges from 0 to 100, and any value above 80 indicates the overbought state of the market, and any value below 20 indicates the oversold state. These overbought / oversold conditions indicate a possible price reversal. However, do not forget to use this indicator carefully during a strong trend in the market. Because the indicator can remain in the oversold or overbought area for a long time, and the price can go far from the entry point to the deal, and you will get stop loss. Therefore, it is recommended to combine Stochastic Oscillator with other indicators in order to receive reliable and accurate signals in the market.
Stochastic Oscillator indicator formula
The stochastic oscillator consists of two lines:
- % K is the main (fast) line. Marked by a solid line on the indicator;
- % D - signal (slow) line. Indicated by a dashed line.
The stochastic oscillator is calculated using the following formula:
where max (Hn) is the highest maximum for the period N;
min (Ln) - the smallest minimum for the period N;
Co - closing price for the current period.
that is, the moving average of% K with period M.
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Default indicator settings
The default period value for the Stochastic indicator is 14 regardless of the timeframe. This can be an hourly chart, daily, weekly, monthly or intraday period. The 14-period% K will use the “most recent close”, “the highest high for the last 14 periods” and “the lowest low for the last 14 periods”. % D is a 3-day simple moving average of% K. As a rule, use Stochastic Oscillator with a period of 14; 3; 3 or 5; 3; 3. If necessary, you can change the stochastic period depending on the timeframe and trading style to make it more sensitive to price changes or, conversely, slow down.
Installing and configuring the Stochastic Oscillator indicator
Stochastic Oscillator is a popular indicator on the market and is available by default in the MetaTrader 4. You can easily apply this indicator to your chart by following these steps.
Open the MT4 terminal and click Insert - Indicators - Oscillators - Stochastic Oscillator.
A window will appear in which you can change the settings to suit your preferences.
As you can see in the figure below, we applied the stochastic oscillator to the 60-minute EURUSD chart.
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Trading strategies using the Stochastic Oscillator indicator
As you already know, stochastic is a leading indicator. Most traders use only this indicator to trade on the market. But if you can combine this indicator with some other indicators, this will give you a stronger advantage in the market. Below are some of the possible strategies.
Strategy 1: Stochastic Oscillator + Moving Averages
In this strategy, we combine Stochastic Oscillator with simple moving averages to trade GBPUSD . We use 9 and 5-period moving averages and the Stochastic indicator with default settings.
To enter the transaction, the following conditions must be met:
- The stochastic oscillator should reach the overbought or oversold area and give a sharp reversal;
- The moving average for 9 periods should cross the moving average for 5 periods.
We recommend that you use this strategy only when the market is trending, since moving averages work best in trending markets.
Transaction for sale
As you can see in the chart below, GBPUSD was in a rollback state. Look at the circles we marked. When the moving averages crossed, the Stochastic Oscillator made a sharp turn. This is a strong sell signal.
If you opened a deal to sell when this strategy gave us the first signal, you would have made 40 points in the market. If you entered a deal to sell when this strategy gave us a second signal, you would have made 50 points in the market. This is a proven strategy used by traders to generate reliable signals.
In the 15-minute CHFJPY chart below, this strategy gave us three buy signals. When the stochastic reached the oversold zone and gave a sharp reversal, the moving averages crossed. This is a potential buy signal.
You would receive 20, 25 and 30 points in the first, second and third trading signals, respectively.
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Strategy 2: Stochastic Oscillator + RSI
In this strategy, we combine a stochastic oscillator with an index of relative strength. Signals are generated when both indicators reach overbought / oversold levels and give a sharp reversal. We also combine stochastic with RSI divergence to generate potential trading signals.
On the lower hourly chart of EURCHF, both indicators reach the overbought zone and give a sharp reversal, which is a sell signal. You can close your deal when any of the indicators reaches the oversold zone.
On the lower hourly chart of EURCAD, both indicators reached the oversold zone and gave a sharp reversal, which is a buy signal.
Stochastic Oscillator and RSI - divergence strategy
Divergence is when the price goes one way and the indicator goes the other way. This is a preliminary sign of a trend change in the market.
On the lower hourly chart of EURNZD, both indicators have difficulty increasing, and the price also loses its dynamics. This is a great sign of a trend reversal.
Disadvantages of the Stochastic Oscillator indicator
As mentioned earlier, the main drawback of this indicator is that it gives false signals in a strong trending market. Because in strong trending markets, sometimes prices rise or fall sharply, and the stochastic continues to move in the overbought / oversold area, thereby generating false signals. That's why we recommend that you use stochastic in combination with other reliable indicators for making trading decisions.
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Overbought and oversold are important areas that traders use to receive trading signals from the market, and the Stochastic Oscillator indicator helps us identify them. Any value above 80 is considered overbought, and below 20 - oversold. But using only one indicator for trading is dangerous. It is better to combine the stochastic oscillator with other indicators. You can use the ready-made strategies mentioned above, or experiment with other indicators. Good luck with your trading!
Read also the article "How to determine the trend in Forex?".