What is the Stochastic Oscillator?

IntermediateOct 11, 2023
The stochastic oscillator is a momentum indicator that helps traders gain valuable insights into market behavior. It can enhance trading decisions when learned well.
What is the Stochastic Oscillator?

The stochastic oscillator is a technical indicator used in technical analysis to determine the direction and end of a trend. The stochastic oscillator uses a mathematical approach to calculate historical price data, volume, and other relevant information to predict the direction of an asset. Mainly, the stochastic oscillator is used to determine the momentum of an asset.

The stochastic oscillator is one of the lesser-known indicators for Crypto, Stocks, and Forex traders. Despite its lesser degree of prominence, it can help traders predict market movements to a reasonable degree.

Understanding the Stochastic Oscillator

As the name suggests, the stochastic oscillator is classified as an Oscillator. In trading, oscillators are technical indicators used to determine when an asset is overbought or oversold, although on a short-term basis and depending on the timeframe used.

The oscillator creates a band or strip that moves along two price levels to achieve this. These price levels also act as support and resistance or threshold levels. Technical analysts use stochastics to find buying and selling opportunities by considering the asset’s momentum.

Traders use the stochastic oscillator to determine the momentum of an asset before the actual price movement takes place. To traders, being aware of such momentum prior is beneficial so that they can spot possible trend reversals and, in turn, capitalize on opportunities. In other words, the stochastic oscillator serves as a leading indicator that points to a move in a direction before it happens on the chart.

The stochastic oscillator creates a band or strip along two price levels, which indicates when an asset is overbought or oversold. The asset is considered overbought when the indicator’s value moves toward the upper price level. The asset is considered oversold when it moves toward the lower price level.

How does the Stochastic Oscillator Work?

The stochastic oscillator derives an asset’s percentage price range or field by calculating the difference between the recent closing price and the high and low prices over a time a trader chooses. The oscillator’s value provides readings that range from 0-100 and is multiplied by 100 to get a percentage that gives insight into the asset’s momentum. The default time set by the stochastic oscillator is 14, similar to the relative strength index.

The stochastic oscillator has two range-bound lines: %K and %D. By default, the %K period is set to 5, the %D period is set to 3, and the slowing is set to 3. The default setting is shown on MetaTrader 5 below:

Source: MetaTrader 5

The %K line defines the price range by comparing an asset’s high and low within an n _period (where _n refers to a given period chosen by the trader. By default, the indicator sets this at 14). %D is simply a moving average of the %K line. %K is regarded as the fast line, while %D is regarded as the slow line.

Mathematically, the formula for calculating the stochastic oscillator is %K=(C-L14) / (H14-L14) ×100.

  • C is the current closing price.
  • L14 is the lowest point the price got to within the last individual 14-day period (the 14 period is set based on the timeframe the indicator is applied to, for example, weekly, daily, or hourly. On an hourly chart, it reads over the last 14 hours trading sessions).
  • H14 refers to the highest point price reached within the last individual 14-day period. The chart below illustrates how the stochastic oscillator shows the momentum of an asset within the previous 14 trading sessions on a 1-hour chart.

Source: MetaTrader 5

In the chart above, the %K line is represented by the green line, and the %D line, which acts as a moving average, is represented by the red line.

Interpreting the Stochastic Oscillator’s Readings

The price scale from 0-100 illustrates the strength of the market’s momentum and states whether the market is overbought or oversold. When the oscillator’s value reads above 80, the market is overbought. When it reads below 20, it indicates that it is oversold.

When the oscillator’s value reads below or above 50, it suggests a tilt into selling or buying conditions within the upper or lower portions of the trading range. When the oscillator indicates overbought or oversold market conditions, it can signal potential trend reversals.

When the %K and %D lines intersect, they can point to entry and exit signals and possible market reversal patterns.

https://s3.ap-northeast-1.amazonaws.com/gimg.gateimg.com/learn/2fb31146f6264ad3a6d76019bee59d085600a885.png

Source: MetaTrader 5

As the chart illustrates, when the oscillators cross over each other or intersect above the 80 range, it signals a selling opportunity because it indicates an overbought market condition.

Intersecting below the 20 range signals a buying opportunity because it means an oversold market condition. If the stochastic oscillator crosses within the 50 range, it is risky to take a trade signal because there is still an equilibrium between buyers and sellers.

Effective Strategies for Using the Stochastic Oscillator in Trading

Although the stochastic oscillator is a helpful tool that gives insights into a market’s trade momentum, combining its signals with other technical indicators is beneficial. It is essential to do this because the stochastic oscillator, as with any indicator, lags and may not capture the broad narrative of the market. The stochastic oscillator can be incorporated with other trading strategies, such as:

Divergence Trading

In trading, divergence is a phenomenon that occurs when the price of an asset moves in the opposite direction of an indicator. In other words, price is moving differently from how the indicator moves. For example, the price of an asset is making higher highs while the stochastic oscillator is making lower highs. Traders read this unusual activity as a sign of a possible weakening and reversal of a trend.

A bullish divergence pattern occurs when the price makes a lower low while the stochastic oscillator makes a higher low. It is a bearish divergence pattern if the price makes a higher high while the stochastic oscillator makes a lower high. The charts below illustrate this phenomenon for bearish and bullish divergence patterns.

Source: MetaTrader 5 | Bearish Divergence Pattern

Source: MetaTrader 5 | Bullish Divergence Pattern

Traders can use the divergence strategy to identify potential trend reversals. Still, actual trade positions should not be made until the signal from the oscillator is confirmed with other indicators, such as the RSI or MA.

Stochastic Oscillator and Moving Average Crossovers

The stochastic crossover is best used with divergence. As explained earlier, when the fast and slow lines cross over each other, they give trade entry signals, especially when they intersect along the 80 or 20 range. A trader can combine this signal with an MA crossover on the chart as indicated below:

Source: MetaTrader 5

From the chart above, the Stochastic Oscillator crossover was above the 80 range, signaling an overbought market condition, while the MA crossover signals a bearish pattern.

Combining these two signals gives a trader confidence to take a short trade entry. Stop loss can be placed above the high, while the trader can take profit targets at the 50 or 20 regions, depending on the trader’s evaluation of the trend’s strength.

Stochastic Oscillator and Support and Resistance Levels

Traders use the threshold levels of the stochastic oscillator with support and resistance levels on the chart. The threshold levels used are the 80 and 20 regions, and when the price hits these levels, traders take it as a first indication of a potential trade signal.

For example, suppose the price is at a resistance level on the candlestick chart, and the stochastic oscillator is above the 80 regions, indicating an overbought market condition. In that case, it may be a good signal to sell, as illustrated in the chart below:

Source: MetaTrader 5

When taking a trade entry using this strategy, stop loss can be placed above the resistance level, as shown in the chart. In contrast, profit targets can be taken when the market approaches 50 or 20 regions on the stochastic oscillator.

Tips for Using the Stochastic Oscillator Effectively

Even though the stochastic oscillator can provide early insights into trade signals, it is essential to be mindful of tips to enhance better trading.

Choose the Right Timeframes

Choose the timeframes that are best suited for your trading style. If you are a scalper, using the stochastic oscillator on timeframes to take trade signals, for example, the 15-minute or the 5-minute chart, is best.

Use appropriate settings on the stochastic oscillator that best fit the timeframe you will be using concerning the period and the %K and %D settings.

Combine with Other Technical Indicators and Strategies

Traders can use other technical analysis tools and strategies to validate the signals generated from the stochastic oscillator, like the RSI, MACD, MAs, support, resistance levels, double tops and bottoms, and head and shoulders.

Practice Risk Management

No matter how good a trade indicator or strategy is, it is essential always to use appropriate position sizing to manage risk. Always employ reasonable risk and trade management practices to mitigate against the uncertainty of the markets.

Advantages of Trading with the Stochastic Oscillator

  • Momentum Insight: The stochastic oscillator provides valuable insights into an asset’s momentum, helping traders evaluate the strength of a trend.
  • Demand and Supply Insight: The stochastic oscillator helps to identify overbought or oversold market conditions, aiding in pinpointing market reversals.
  • Leading Indicator: It serves as a leading Indicator, providing Insights and signals ahead of future price movements on the chart.
  • Simple Interpretation: The oscillator is simple to read and offers clear signals. Readings above 80 suggest overbought market conditions, while readings below 20 indicate oversold conditions.
  • Effective for spotting reversals: It helps traders identify divergence patterns on the chart, which can signal potential trend reversals.

Disadvantages of Trading with the Stochastic Oscillator

  • False Signals: The stochastic oscillator can still generate false signals, especially in ranging or choppy markets, leading to bad trading decisions. It is beneficial to combine the indicator with different technical strategies.
  • Subjectivity: Interpretations can vary among traders due to the different settings and timeframes, offering varying signals.
  • Not Standalone: To maximize trading accuracy, traders must combine the stochastic oscillator with other technical indicators or strategies, sometimes complicating the decision-making process.

Traders must weigh these pros and cons and consider how the stochastic oscillator aligns with their trading style, risk tolerance, and strategy.

Conclusion

Incorporating the stochastic oscillator into your trading system can amplify your decision-making process and provide insights into momentum, trend direction, and potential reversals. It can help traders to navigate the complexities of the financial markets.

The stochastic oscillator should be used as a guide that offers perspective on market behavior, and it is best used when paired with other indicators to validate its signals in addition to thorough analysis. Always prioritize risk management strategies to navigate the unpredictable nature of trading.

Author: Bravo
Translator: Cedar
Reviewer(s): Matheus、Wayne Zhang、Ashley He
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