The Stochastic Oscillator Trading Guide
The Stochastic Oscillator was developed in the 1950s and, due to its versatile nature, remains one of the most popular technical indicators used in Forex and stock trading today.
In this article, we will explain what the Stochastic Oscillator is, demonstrate how it can be used to trade online and share the best Stochastic indicator settings for day trading and swing trading. Furthermore, we will provide you with a Stochastic Oscillator trading strategy for scalping, day trading and swing trading!
Table of Contents
Stochastic Oscillator: An Introduction
The Stochastic Oscillator is a momentum indicator, which compares a specific closing price of an asset to its high-low range over a set number of periods. The basic premise of the indicator is that momentum precedes the price, so the Stochastic Oscillator could signal an actual movement just before it happens.
The Stochastic is a range-bound oscillator, operating between 0 and 100 by default. There are two lines shown on the indicator itself – the slow oscillating %K line and a moving average of %K -which we refer to as %D. Slowing is usually applied to the indicator's default setting as a period of 3.
This is what the default setting looks like on the MetaTrader 5 trading platform:
This is what the Stochastic indicator looks like when applied to a price chart with the default settings:
Stochastic Oscillator: The Formula
The %K and %D lines of the Stochastic Oscillator are calculated as follows:
- %K = 100 [(C – L14) / (H14 – L14)]
- C is the current closing price
- L14 is the lowest price when looking back at the 14 previous trading sessions
- H14 is the highest price when looking back at the 14 previous trading sessions
- %K tracks the most recent market rate for the currency pair
- %D = 3-period simple moving average (SMA) of %K. It is also called the 'stochastic slow' due its slower reactions to market price changes, as compared to %K.
The time periods referred to are the standard periods used, however, this can be changed for different needs in the settings of the indicator - as seen in the image of the settings above.
Stochastic Divergence
Understanding Stochastic divergence is very important, as it can be used to signal a trend reversal.
When the price is making a lower low, but the Stochastic is making a higher low – we call it a bullish divergence. If the price is making a higher high, but the Stochastic is making a lower high – we call it a bearish divergence.
Divergence will almost always occur right after a sharp price movement higher or lower. Divergence is just a cue that the price might reverse, and it's usually confirmed by a trend line break. Below is an example of bullish divergence with a confirmed trend line breakout:
This is an example of bearish divergence with a trend line breakout:
Stochastic Oscillator Strategy: Intraday Trading
This Stochastic Oscillator trading strategy uses the following indicators with the following settings:
- Admiral Keltner (requires MetaTrader Supreme Edition - MTSE)
- Stochastic Oscillator (15,3,3)
- Admiral Pivot (D1) – recommended (also requires MTSE)
The correct setting for the Admiral Keltner are as follows:
This system is suitable for trading the major Forex pairs (EUR/USD, GBP/USD, USD/JPY, USD/CHF, AUD/USD), as well as GBP/JPY, AUD/JPY, NZD/JPY and GBP/NZD. The clear benefit of the Admiral Keltner is that it shows the correct price range, confirmed by the Stochastic momentum breakout.
The system relies on the overbought/oversold (OB/OS) stochastic zones and is traded on an H1 chart.
The Stochastic Oscillator day trading strategy rules are as follows:
Long Trades:
- Close of candle below the bottom Keltner line and signal line on the Stochastic (the red dotted line) at or below 20
- An up candle with the signal line on the Stochastic still at or below 20
Short Trades:
- Close of candle above the top Keltner and signal line on the Stochastic at or above 80
- A down candle with the signal line on the Stochastic still at or above 80
Stop-Loss:
- For long trades - 5 pips below the next Admiral Pivot support
- For short trades - 5 pips above the next Admiral Pivot resistance
Target:
- For long trades, targets are the closest pivot points to the upside
- For short trades, targets are the closest pivot points to the downside
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.
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Long Entry Example:
Short Entry Example:
Stochastic Oscillator Strategy: Scalping
This scalping system utilises different Stochastic indicator settings to the day trading strategy above. 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.
Indicators:
- Stochastic (13,8,8) with levels 80, 50, 20
- Admiral Pivot (set on H1)
Time Frame:
- M5 for entries and M30 for trend direction
Pairs:
- EUR/USD (focus), GBP/USD, GBP/JPY, USD/JPY, AUD/USD, EUR/JPY, USD/CHF
Long Entries:
- The Stochastic on the M30 time frame should be just above 20 or just above 50 - signaling an uptrend.
- Move to the M5 time frame
- The Stochastic should cross 20 or 50 from below; then place your long entry
Short Entries:
- The Stochastic on the M30 time frame should be just below 80 or just below 50 - signaling a downtrend.
- Move to the M5 time frame
- The Stochastic should cross 20 or 50 from above; then place your short entry
Stop-loss:
- 5 pips below the previous M30 candle for long entries.
- 5 pips above the previous M30 candle for short entries.
Target:
- Targets are Admiral Pivot points set on a H1 chart. H1 pivots will change each hour, that's why it is very important to pay attention to the charts. This is a pure scalping system.
Pro Tip: We follow the blue line on the Stochastic indicator in this Stochastic Oscillator trading strategy.
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Long Entry Example:
In the M30 chart below, the blue line of the Stochastic Oscillator has just crossed above 50 from below. We are looking for long entries.
We move to the M5 time frame and wait until the Stochastic crosses 20 or 50 from below to make our long entry.
Short Entry Example:
In the chart below, the Stochastic Oscillator has just crossed below 50 from above. We are looking for short entries.
When the trend was identified on the M30 chart, we switch to the M5 chart – where we receive a signal to go short.
Crossovers in the Overbought and Oversold Zone
Contrary to many scalping and day systems that rely on a single Stochastic line (usually the faster one - the solid line in previous examples) identifying Overbought/Oversold (OB/OS) conditions and crossovers is slightly different.
Generally, the zone above 80 indicates an overbought region, and the zone below 20 is considered an oversold region. A crossover signal occurs when both Stochastic lines cross in the overbought or oversold region.
An overbought sell signal is given when the oscillator is above 80, and the solid blue line crosses the red dotted line, while still above 80. Conversely, an oversold buy signal is given when the oscillator is below 20, and the solid blue line crosses the dotted red line, while still below 20.
80 and 20 are the most common levels used, but can also be modified as required. For OB/OS signals, the Stochastic setting of 14,3,3 works well.
The higher the time frame the better, but usually a H4 or a Daily chart is the optimum for day traders and swing traders. The advantage of identifying overbought/oversold crossovers is that traders could jump in a trade and ride the move from the earliest point. The drawback of this approach is that the price can sometimes remain in the OB/OS zone for a long time, making crossovers futile until the Stochastic indicator actually breaks 80 or 20.
Stochastic Oscillator Strategy: Swing Trading
This Stochastic Oscillator trading strategy uses the following indicators:
- SMA (150)
- Admiral Pivot (set on monthly pivot points)
- Stochastic (6,3,3) with levels at 80 and 20
- RSI (3) with levels at 70 and 30
This is a swing trading strategy and suitable for part-time traders and traders who don't like to sit watching charts all day. It is traded on a daily time frame. In order to enter long or short positions, the following criteria must be met:
Long:
- The price needs to be above the 150 SMA
- The RSI needs to be either below 30 or crossing 30 from below
- The Stochastic needs to cross 20 from below
- Enter a long position
Short:
- The price needs to be below the 150 SMA
- The RSI needs to be either above 70 or crossing 70 from above
- The Stochastic needs to cross 80 from above
- Enter a short position
Pro Tip: The price needs to be close to the SMA before placing an entry.
Targets are daily pivot points shown by the Admiral Pivot indicator. Traders can also opt to use a trailing stop. For uptrends, a trailing stop is activated for the first time when the Stochastic reaches 80. For downtrends, a trailing stop is activated when the Stochastic reaches 20. For starters, traders can move trailing stops in the following way:
- For uptrends, a trailing stop is placed below the previous candle’s lowest price and is moved with each new price candle
- For downtrends, a trailing stop is placed above the previous candle's highest price and is moved with each new price candle
A Stop-loss is placed just above the most recent swing high (for short entries) and just below the most recent swing low (for long entries).
Long Entry Example:
Sell Entry Example:
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Conclusion
You should now be more familiar with the Stochastic Oscillator and understand why it is such a popular indicator in Forex trading. The Stochastic Oscillator trading strategies that we have explored above can also be a unique way to look into the markets.
The Stochastic indicator works best when using the standard indicator that you can find on both the MT4 and MT5 platforms. Some custom-made Stochastic indicators may cause slowdowns, and may even use different formulas. Before trying any of these trading strategies on the live markets, it is highly recommended that you open a demo trading account in order to practice in a risk-free environment.
Other articles you may find interesting:
- 11 Economic Indicators That Impact the Forex Market
- Overview of the Best MT5 Indicators
- The Best Forex Technical Indicators
Frequently Asked Questions
What is a Stochastic Oscillator?
A Stochastic Oscillator is a technical analysis instrument that is used in trading and investing to determine the price momentum of a financial asset. It assists traders in identifying overbought and oversold market circumstances. The oscillator is made up of two lines, %K and %D, that move from 0 to 100. It compares a closing price to its price range over a given time period to assist traders in predicting probable trend reversals.
How does the Stochastic Oscillator work?
The Stochastic Oscillator calculates %K as the difference between the current closing price and the lowest price within a chosen time frame, divided by the difference between the highest and lowest prices within that same period. %D is a smoothed moving average of %K. When %K crosses above %D, it's considered a buy signal, suggesting potential upward momentum. Conversely, when %K crosses below %D, it's a sell signal, indicating potential downward momentum.
What does the Stochastic Oscillator indicate?
The Stochastic Oscillator provides insights into a market's potential trend reversal points. It helps traders identify situations where an asset might be overbought (values near 100) or oversold (values near 0), which could signal upcoming price corrections. However, it's important to use the oscillator in conjunction with other technical and fundamental analysis tools for more accurate trading decisions, as false signals can occur, especially in strongly trending markets.
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