The Stochastic Oscillator Trading Guide

Alexandros Theophanopoulos
16 Min read

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! 

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: 

Depicted: Admirals MetaTrader 5 - Stochastic Oscillator settings 

This is what the Stochastic indicator looks like when applied to a price chart with the default settings: 

Depicted: Admirals MetaTrader 5 – GBPUSD Daily Chart. Date Range: 23 April 2020 – 16 June 2021. Date Captured: 16 June 2021. Past performance is not a reliable indicator of future results. 

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: 

Depicted: Admirals MetaTrader 5 – EURUSD H4 Chart. Date Range: 28 January 2021 – 16 June 2021. Date Captured: 16 June 2021. Past performance is not a reliable indicator of future results. 

This is an example of bearish divergence with a trend line breakout: 

Depicted: Admirals MetaTrader 5 – GBPJPY H4 Chart. Date Range: 28 January 2021 – 16 June 2021. Date Captured: 16 June 2021. Past performance is not a reliable indicator of future results. 

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: 

Depicted: Admirals MetaTrader 5 Supreme Edition - Admiral Keltner Indicator Settings 

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: 

Depicted: Admirals MetaTrader 5 – GBPJPY H1 Chart. Date Range: 9 June 2021 – 17 June 2021. Date Captured: 17 June 2021. Past performance is not a reliable indicator of future results. 

Short Entry Example: 

Depicted: Admirals MetaTrader 5 – GBPNZD H1 Chart. Date Range: 9 June 2021 – 17 June 2021. Date Captured: 17 June 2021. Past performance is not a reliable indicator of future results. 

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. 

Depicted: Admirals MetaTrader 5 – USDCHF M30 Chart. Date Range: 15 June 2021 – 17 June 2021. Date Captured: 17 June 2021. Past performance is not a reliable indicator of future results. 

We move to the M5 time frame and wait until the Stochastic crosses 20 or 50 from below to make our long entry. 

Depicted: Admirals MetaTrader 5 – USDCHF M5 Chart. Date Depicted: 17 June 2021. Date Captured: 17 June 2021. Past performance is not a reliable indicator of future results. 

Short Entry Example: 

In the chart below, the Stochastic Oscillator has just crossed below 50 from above. We are looking for short entries. 

Depicted: Admirals MetaTrader 5 – GBPUSD M30 Chart. Date Range: 16 June 2021 – 17 June 2021. Date Captured: 17 June 2021. Past performance is not a reliable indicator of future results. 

When the trend was identified on the M30 chart, we switch to the M5 chart – where we receive a signal to go short. 

Depicted: Admirals MetaTrader 5 – GBPUSD M5 Chart. Date Depicted: 17 June 2021. Date Captured: 17 June 2021. Past performance is not a reliable indicator of future results. 

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. 

Depicted: Admirals MetaTrader 5 – EURUSD Daily Chart. Date Range: 19 November 2020 – 17 June 2021. Date Captured: 17 June 2021. Past performance is not a reliable indicator of future results. 

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: 

Depicted: Admirals MetaTrader 5 – GBPUSD Daily Chart. Date Range: 24 April 2020 – 17 June 2021. Date Captured: 17 June 2021. Past performance is not a reliable indicator of future performance. 

Sell Entry Example: 

Depicted: Admirals MetaTrader 5 – USDJPY Daily Chart. Date Range: 24 April 2020 – 17 June 2021. Date Captured: 17 June 2021. Past performance is not a reliable indicator of future performance. 

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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:

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.

 

INFORMATION ABOUT ANALYTICAL MATERIALS:

The given data provides additional information regarding all analysis, estimates, prognosis, forecasts, market reviews, weekly outlooks or other similar assessments or information (hereinafter “Analysis”) published on the websites of Admiral Markets investment firms operating under the Admiral Markets and Admirals trademarks (hereinafter “Admirals”). Before making any investment decisions please pay close attention to the following:
1. This is a marketing communication. The content is published for informative purposes only and is in no way to be construed as investment advice or recommendation. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research, and that it is not subject to any prohibition on dealing ahead of the dissemination of investment research.
2. Any investment decision is made by each client alone whereas Admirals shall not be responsible for any loss or damage arising from any such decision, whether or not based on the content.
3. With view to protecting the interests of our clients and the objectivity of the Analysis, Admirals has established relevant internal procedures for prevention and management of conflicts of interest.
4. The Analysis is prepared by an independent analyst (hereinafter “Author”) based on the personal estimations of Alexandros Theophanopoulos (SEO and Content Specialist).
5. Whilst every reasonable effort is taken to ensure that all sources of the content are reliable and that all information is presented, as much as possible, in an understandable, timely, precise and complete manner, Admirals does not guarantee the accuracy or completeness of any information contained within the Analysis.
6. Any kind of past or modeled performance of financial instruments indicated within the content should not be construed as an express or implied promise, guarantee or implication by Admirals for any future performance. The value of the financial instrument may both increase and decrease and the preservation of the asset value is not guaranteed.
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