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# The Stochastic Indicator In Depth

July 08, 2019 07:00 UTC

The Stochastic is an indicator that allows for huge versatility in trading. It was developed by George C. Lane in the late 1950s. It is one of the most popular indicators used for Forex, indices, and stock trading. Some might find it Interesting to know that "stochastic" is a Greek word for random. Stochastic trading has been very popular among Forex, Indices, and CFD traders.

We can use the Stochastic Indicator for the following activities and purposes:

In this article, you will learn the best Stochastic settings for intraday and swing trading. The basic premise is that momentum precedes the price, so the Stochastic oscillator, being a momentum indicator, could signal the actual movement just before it happens.

## What is the Stochastic Indicator?

The Stochastic oscillator is a momentum indicator. It is a range-bound (100 and 0 by default) oscillator that shows the location of the close relative to the high-low range over a set number of periods. There are two lines shown on the indicator itself – the slow oscillating %K line and a moving average of the same %K that 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 4 trading platform:

Source: MetaTrader 4 - Setting the parameters for the Stochastic Oscillator indicator

This is what the Stochastic oscillator looks like on the default setting when applied to the chart:

Depicted: MetaTrader 4 - GBP/USD D1 Chart - Disclaimer: Charts for financial instruments in this article are for illustrative purposes and does not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (CFDs, ETFs, Shares). Past performance is not necessarily an indication of future performance.

## The Stochastic Oscillator Formula

• The Stochastics oscillator is measured using the %K and %D lines
• %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 of %K. It is also called the 'stochastic slow' due its slower reactions to market price changes, as compared to %K.

## The Stochastic Divergence

Understanding Stochastic divergence is very important. Similar to the MACD indicator, when the price is making a lower low, but the Stochastic is making a higher low – we call it a bullish divergence. If the Stochastic is making a lower high, but the price is making a higher 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. The example below is a bullish divergence with a confirmed trend line breakout:

Depicted: MetaTrader 4 - EUR/USD H1 Chart - Disclaimer: Charts for financial instruments in this article are for illustrative purposes and does not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (CFDs, ETFs, Shares). Past performance is not necessarily an indication of future performance.

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

Depicted: MetaTrader 4 - EUR/USD H1 Chart - Disclaimer: Charts for financial instruments in this article are for illustrative purposes and does not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (CFDs, ETFs, Shares). Past performance is not necessarily an indication of future performance.

2. Stochastic (15,3,3)
3. Admiral Pivot (D1) – recommended

The system is traded on M5-minute time frames, which is suitable for trading major Forex pairs (EUR/USD, GBP/USD, USD/JPY, USD/CHF, AUD/USD), and also including 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 OB/OS (overbought/oversold) stochastic zones. The system is traded on a H1 chart, and uses Admiral Pivot set on a Daily (D1). The best settings for the Stochastic oscillator in this strategy are 15,3,3. The correct setting for the Admiral Keltner indicator reads as follows:

Source: MetaTrader 4 Supreme Edition - Selecting inputs for the Admiral Keltner indicator

The rules are as follows:

• Close of candle below the bottom Keltner line and signal line on stochastic at or below 20
• An up bar with the signal line on stochastic still at or below 20
• PSAR below the candle

• The candle close above the top Keltner and signal line on the Stochastic at or above 80
• A down bar with the signal line on the Stochastic still at or above 80
• PSAR below the candle

Stop-Loss

1. For long trades, 5 pips below the next Admiral Pivot support
2. For short trades, 5 pips above the next Admiral Pivot resistance

Target

• For long trades, targets are the pivot points next to the upside
• For short trades, targets are the pivot points next to the downside

The Stochastic 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. Trading with the Stochastic should be a lot easier this way.

Depicted: MetaTrader 4 - GBP/USD H1 Chart - Disclaimer: Charts for financial instruments in this article are for illustrative purposes and does not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (CFDs, ETFs, Shares). Past performance is not necessarily an indication of future performance.

## Scalping With the Stochastic Indicator

This scalping system uses the Stochastic on different settings. The point of using the Stochastic this way is the momentum bounce. The bounce is reflected with a unique Admiral Pivot set on hourly time frames.

Indicators:

• Stochastic (13,8,8) with levels 80,50,20
• Admiral Pivot (requires MTSE, 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 signals an uptrend. (The Stochastic should be just above 20 or just above 50)
• Move to the M5 time frame
• The Stochastic should cross 20 from below; then place your long entry

Short entries:

• The Stochastic on the M30 time frame signals a downtrend. (The Stochastic should be just below 80 or just below 50)
• Move to the M5 time frame
• The Stochastic should cross 20 from below; then place your long entry

Stop-loss:

• Stops go 5 pips below the previous M30 candle for long entries, and 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 scalping system. Example for short entries: The Stochastic oscillator has just crossed below 80 from above. We are looking for short entries:

Depicted: MetaTrader 4 - GBP/USD M30 Chart - Disclaimer: Charts for financial instruments in this article are for illustrative purposes and does not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (CFDs, ETFs, Shares). Past performance is not necessarily an indication of future performance.

When the M30 trend was identified, the M5 Stochastic signalled two short entries.

Depicted: MetaTrader 4 - GBP/USD M5 Chart - Disclaimer: Charts for financial instruments in this article are for illustrative purposes and does not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (CFDs, ETFs, Shares). Past performance is not necessarily an indication of future performance.

Example for long entries: The Stochastic oscillator has just crossed above 20 from below. We are looking for long entries:

Depicted: MetaTrader 4 - EUR/USD M30 Chart - Disclaimer: Charts for financial instruments in this article are for illustrative purposes and does not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (CFDs, ETFs, Shares). Past performance is not necessarily an indication of future performance.

We move to the M5 time frame and wait until the Stochastic crosses 20 or 50 from below. The long entry is made as soon as the Stochastic blue line crosses 50.

Depicted: MetaTrader 4 - EUR/USD M30 Chart - Disclaimer: Charts for financial instruments in this article are for illustrative purposes and does not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (CFDs, ETFs, Shares). Past performance is not necessarily an indication of future performance.

## Stochastic Crossovers in the Overbought/Oversold Zone Explained (OB/OS)

Contrary to many scalping and intraday systems that rely on a single Stochastic line (usually the faster one – the blue line) identifying 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 oversold sell signal is given when the oscillator is above 80, and the blue line crosses the red line, while still above 80. Conversely, an overbought buy signal is given when the oscillator is below 20, and the blue line crosses the 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 pretty well.

The higher the time frame, the better, but usually, a 4h or a Daily chart is the optimum for day/swing traders. The advantage of identifying overbought/oversold crossovers is that traders could jump in a trade early and ride the move from the earliest point. The drawback of this approach is that the price can remain in the OB/OS zone for a long time, making crossovers futile until the Stochastics actually breaks 80 or 20.

Depicted: MetaTrader 4 - CAD/JPY H4 Chart - Disclaimer: Charts for financial instruments in this article are for illustrative purposes and does not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (CFDs, ETFs, Shares). Past performance is not necessarily an indication of future performance.

This strategy uses the following indicators applied on the chart:

1. SMA (150), green colour, can be changed;
2. Admiral Pivot (MTSE tool, set on monthly pivot points)
3. Stochastic (6,3,3) with levels at 80 and 20
4. RSI (link) (3) with levels at 70 and 30
5. Time frame: Daily

This is a swing trading trading strategy, suitable for part-time traders and traders who don't like to watch the charts very often. It is traded on a daily time frame. Below, you'll see the Admiral Pivot indicator set exactly as it should be for this strategy.

• 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

Sell:

• 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. The closest the price is to the SMA before 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 bar's lowest price and is moved with each new price bar
• For downtrends, a trailing stop is placed above the previous bar's highest price and is moved with each new price bar

• If a trader is in a buy position and the Admiral Monthly pivot resistance is broken, you could move your stop-loss a couple of pips below the resistance, securing the profits
• If a trader is in a sell position and the Admiral Monthly pivot support is broken, you could move your stop-loss a couple of pips above the support, securing the profits

A Stsop-loss is placed just above the most recent swing high (for short entries) and just below the most recent swing low (for long entries).

Sell Entry Example

Depicted: MetaTrader 4 - GBP/USD D1 Chart - Disclaimer: Charts for financial instruments in this article are for illustrative purposes and does not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (CFDs, ETFs, Shares). Past performance is not necessarily an indication of future performance.

Depicted: MetaTrader 4 - GBP/USD D1 Chart - Disclaimer: Charts for financial instruments in this article are for illustrative purposes and does not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (CFDs, ETFs, Shares). Past performance is not necessarily an indication of future performance.

Depicted: MetaTrader 4 - EUR/NZD D1 Chart - Disclaimer: Charts for financial instruments in this article are for illustrative purposes and does not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (CFDs, ETFs, Shares). Past performance is not necessarily an indication of future performance.

Bear in mind that the Stochastic oscillator in Forex trading is often used with the RSI, the MACD, the CCI, and even the ADX indicator, and the trading strategies that we've used above can also be a unique way to look into the markets.

The Stochastic oscillator works best when applied as a standard MetaTrader 4 indicator that you can find on the MT4 platform, as some custom-made Stochastic indicators may cause slowdowns, and may even use different Stochastic formulas. It is highly advised to open a demo trading account first and practise these strategies, so that you can successfully apply them later on your live trading account.

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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.

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