Stochastic Oscillator: Find Your Reversal Point
Stochastic Oscillator is one of the most useful indicators among traders worldwide. It was developed at the end of the 1950s. However, it’s popularity hasn’t vanished, but increased even more. Why do traders like this indicator and how can you catch its signals? We have created a complete guide that will tell you everything you need to know about the Stochastic Oscillator.
What Is Stochastic?
The Stochastic Oscillator is one of the technical instruments traders implement to determine buy and sell signals, along with the trend direction. It measures the market momentum and shows possible trend reversals.
The Stochastic Oscillator consists of two lines - %K and %D. It’s placed in the window below the price chart.
The indicator consists of two lines. The fast line is called %K (blue); the slow one is %D (orange). The slow line is the Moving Average of the fast one. Stochastic, like most of the oscillators, is placed below the price chart. Look at the picture below.
How to Implement the Stochastic Indicator in MetaTrader 4
Fortunately, the oscillator is set by default in MetaTrader 4 and most trading platforms. Thus, you don’t have to download it. All you need to do is to click “Insert” – “Indicators.” There you will see groups of indicators, so you choose Oscillators. After this, you will find the Stochastic Oscillator.
The Stochastic Oscillator is set by default in MetaTrader 4 and most trading platforms. The standard settings are 5 for the fast line, 3 for the slow line, and 3 for slowing.
If you are familiar with the technical indicators, you know each of them has unique settings. A great feature of the index is that it can be applied to any timeframe. The standard settings are 5 for the fast line, 3 for the slow line, and 3 for slowing. The indicator compares close prices to prices of the specified period of the timeframe. Thus, the following setting is the price field. It should be low and high.
Still, you can use other settings that may be more suitable for your trading strategy. You can try 14 or 21 for %K, 3 or 5 for %D, and 3 or 5 for the slowing.
How Is Stochastic Built?
Let’s consider how the indicator is calculated. Although the index is measured automatically, it’s worth knowing its formula.
As we said above, the indicator consists of two lines. Thus, each of them should be measured separately. To calculate %K, follow the next steps:
- Subtract the lowest price of 14 previous trading sessions from the current close price.
- Subtract the lowest price of 14 last trading sessions from the highest price of 14 previous trading sessions.
- Divide the first result by the second one.
- Multiply the last result by 100.
To measure the %D line, you should subtract period simple moving average of %K from 3. The %D has a slower reaction to the change of the price.
Types of Stochastic
There are three types of Stochastic Oscillators. They are fast, slow, and full. The type difference is based on the calculation.
There are three types of Stochastic indicators. These are fast, slow, and full.
Fast Stochastic
This type reflects the current price positions regarding the set of a number of previous bars. The fast Stochastic usually has the following settings: 5 for the %K line and 4 for the %D one. The Fast Stochastic has a quicker reaction to price changes.
As for the formula, the %K is calculated as follows:
[(Close Price – Low Price) / (High Price – Low Price)] x 100
The Fast %D line is similar to the standard formula. It’s a simple moving average of the %K line with the period of 3.
Slow Stochastic
There are not many differences to the fast stochastic. However, the slow %K is the same as the fast %D (thus, it’s a 3-period moving average of the fast %K). Simultaneously, the slow %D is also a moving average but of the slow %K. The standard settings for the slow stochastic are 14 of the %K and 3 of the %D line. The slow Stochastic limits the number of false signals.
Full Stochastic
The full Stochastic is like the slow Stochastic, but it includes an additional parameter. It allows an investor to determine the period of the simple moving average besides the standard period of 3. Settings of 14 and 3 are considered as standard for this type.
Read Signals
We are at the most exciting part of this tutorial. Now, you will learn how to read the signals of the indicator.
Stochastic is a range-bound tool, which moves in the area from 0 to 100. It means you can easily determine the points when the market is overbought and oversold. It will give you potential entry and exit signals along with the possible market trend.
There are two main points. These are 20 and 80. Thus, when the indicator is above 80, it’s a sign that the market is overbought. You can expect a downward movement. Readings below 20 signal oversold conditions. This means the market may turn up soon.
20 and 80 are the crucial points that determine when the market is oversold and overbought.
However, that’s not all. Being in these areas, the indicator doesn’t guarantee a 100% reversal. If the market trend is robust, there are risks the price won’t reverse. That’s why it’s worth looking at the indicator’s lines as they were created for a reason.
As we mentioned above, there are two lines: %K and %D. The interaction of them will be crucial for forex signals. You get a sign of an upward movement when %K crosses %D bottom-up and a signal of a downward move when %K breaks %D upside-down. However, the signs will be more precise if the cross is in the overbought area for a sell signal, and in the oversold territory for a buy signal.
Previously, we warned you that there could be a stable trend that will cause fake signals. But we will teach you how to avoid them.
Opening a position on one timeframe, check the current trend on a bigger one.
For example, if you trade on , check the trend on the daily one. If there is a strong trend, don’t open a position against it even if the indicator is in extreme areas. It can stay there for an extended period, and you will just suffer losses. It’s better to trade in the trend. Thus, focus on the signals positively correlated with the current market conditions. For instance, in the case of the uptrend, wait until the indicator forms a buy signal. If you trade in the downtrend, wait for a sell signal.
If this sounds complicated, we created a video for you that will explain Stochastic signals in just a few words. Watch the video and keep it as a tip that you can find fast.
Stochastic Divergence
Divergence is an additional option to catch stochastic signals. Merely saying, divergence is a difference between the direction of the price chart and the indicator. Look at the picture below.
The divergence is an effective method that helps determine price reversals. It’s easily defined using the Stochastic Oscillator.
- If the price falls and forms a lower low, while the Stochastic moves up and forms a higher low at the same time, it’s called a bullish divergence. It means that the market will turn up soon.
- If the price moves up, forming a higher high, while the indicator falls and has a lower high, we have a bearish divergence, which means the market will decline soon.
Benefits and Limitations
It’s not enough to know how to use technical indicators. It is better you know their disadvantages. Knowing the limitations, you will implement the index more efficiently.
Pros | Cons |
Easiness. The stochastic is an easy-to-use indicator. First, it’s a standard indicator of any trading platform. Second, it doesn’t require specific settings. You can use the default ones. | Confirmation. Like any other indicator, the Stochastic needs proof of other indicators. There is a risk the index will be in the oversold or overbought area for an extended period, and the market won’t reverse as you expect. |
Clearness. The indicator provides signals often. Moreover, even a beginner will be able to read them. | Effectiveness. Although the indicator is useful, it may provide wrong signals in times of strong trends. It works better in the periods of consolidation. |
Effectiveness. The Stochastic provides all the signals a trader needs for profitable trading. You can determine the direction of the trend, enter and exit the market at perfect points. |
Stochastic Oscillator and RSI: Are They Different?
These indicators look similar and also give the same signals. But why do we have two instruments when we could use only one?
Similarities | Differences |
Divergence. You can find divergence using any of the indicators. | Crucial points. Stochastic has points of 20 and 80 that determine oversold and overbought conditions, respectively. As for the RSI, these levels are 30 and 70. |
Oscillators. Both technical tools are oscillators. They are used to gauge market momentum. They are range-bound and move from 0 to 100. | Implementation. The Stochastic oscillator works better when the market consolidates, while the RSI is preferable in trends. |
Signals. Both indicators provide buy and sell signals based on the index's location in the overbought and oversold areas. | Lines. The Stochastic has two lines, while the RSI is presented by only one. |
Accuracy. It seems that the point above is not essential. Does it matter whether there are one or two or lines? In this case, it does. Stochastic provides more accurate signals because it has two lines. One of them is a moving average that filters signals. As for the RSI, there is only one line that doesn’t provide 100% precise signals. | |
Aim. The stochastic oscillator was invented to determine the price movement in consecutive ranges. The RSI gauges the speed of price moves. |
Let’s Read the Chart
Everything sounds clear, but when traders start their paths, it can be complicated to understand how to read the price chart. Look at an example below.
You can see that the indicator was in the overbought area. The signal to sell appeared when the %K line (blue) crossed the %D (orange) upside-down. However, we see that the crossover happened several times. Here, we add an additional tip that will limit fake signals. When the fast %K line crosses the %D line, wait until both lines break one of the crucial levels. So, we opened a sell trade, not at point A, but point B.
Great, we opened a sell position. Now, it’s time to determine the take profit point. Again, Stochastic can help us. Wait until the lines touch the opposite crucial point. In our case, we closed the position at point C.
Implement the Stochastic Oscillators: Step by Step
Let’s consider step by step how we can apply the stochastic to the price chart. We will view the GBP/USD pair and H1 chart.
Choose the indicator on the platform where you trade. Place 5,3,3 settings. And look at the chart. In our example, we see that the %K line (blue) crossed the %D line (orange) bottom-up in the oversold area. However, we need additional confirmation. We can get approval of the upward movement from the Inverted Hammer candle (1). However, we see that the indicator hasn’t crossed the 20 level. We should wait until it does it. After, we can open a buy position.
Stochastic Oscillator: Choose Your Strategy
We will consider a trading strategy you can use if you haven’t created your own yet. Still, it’s worth thinking about your strategy, as it’s always better to pick up the conditions that will work for you. If you are a day trader, this strategy will be useful.
Choose the security you want to trade. In our example, we will consider the EUR/USD pair. You will need to switch between 15 and daily charts. Set 3 for the %D line, 5 for the %K line, and 3 for the length.
- Step 1. We should start with the daily chart. It’s an example of the buy signal. Thus, we need to find a point where the indicator lands in the oversold area (below 20). At the same time, the %K line should have crossed the %D line.
We start with the daily chart because it’s crucial to consider the significant trend. We mentioned this rule above. So, we will trade in the direction of this trend. - Step 2. Go back to the 15-minute chart. Here, we need to wait until the lines break below the 20 point. Again the %K line should break above the %D line bottom up.
- Step 3. We need a confirmation that will ensure we can enter the market. We will look for a swing low pattern. It consists of three candlesticks. The second candle should have a lower low, while the third one a higher low.
- Step 4. Are we ready to enter the market? Yes. We should open trade as soon as the following candlestick breaks above the highest point of the swing pattern.
- Step 5. We need to place a stop-loss order. Stop Loss should locate below the swing low pattern. You can set it five pips below the previous low to avoid a false breakout. In our case, it’s 1.15585.
- Step 6. The most interesting point for any trader is to count profit. In this strategy, we can determine the profit on the stop loss level. As the major rule is ½ ratio, you can simply double the distance between the entry point and the stop-loss order. In our case, it’s 1.1579.
You can apply the same strategy for a sell position. You should use the same step but in the opposite way.
Tips for Users of Stochastic Oscillator
Expert advice: You better use the indicator for decision making.because they serve as confirming signals during sideways movements.
Expert advice: A divergence is the most reliable signal of the oscillator. It’s a divergence of peaks of the price chart and the oscillator. For instance, in the uptrend, the rising high of the price chart corresponds with the oscillator's falling peak.
Expert advice: Oscillators' signals are not useful in strong and prolonged trends as they are mostly used for decision-making in times of uncertainty.
We are coming to the end of our tutorial and would like to prevent you from the most common mistakes many traders make when applying the Stochastic Oscillator.
- No confirmation. The first thing many traders forget is confirmation. Although it seems the Stochastic provides accurate signals, there are risks of fake alarms. Thus, traders should find confirmation from other indicators. We would recommend combining the Stochastic with Alligator, Heiken Ashi, and MACD indicators.
- Wrong settings. Some indicators work well in any timeframe with the same settings. However, it doesn’t work for the Stochastic. You need to choose those that will work best on your timeline. The most famous settings are 14 and 3; 21 and 3; 5 and 4.
- Fake signals. Some traders forget that the presence in either overbought or oversold areas doesn’t 100% guarantee a trend reversal. The indicator may stay in the zone for a long time. That’s why it’s worth trading in a trend and waiting until the fast %K line crosses the slow %D line.
Conclusion
To conclude, the Stochastic Oscillator is one of the most popular technical tools. It’s simple and set by default in any trading platform. Moreover, it determines crucial areas such as overbought and oversold, which allows traders enter and exit the market at perfect points.
However, the indicator works differently depending on the settings you choose. That’s why it’s essential to practice before entering the real market. A Libertex demo account allows newbies to gain the experience they need before placing an actual trade, while professional traders can develop their strategies with a new indicator.
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FAQ
Read the answers to the most popular questions about the Stochastic indicator.
What Is the Best Setting for Stochastic?
There is no best setting, but we recommend using 5 and 4; 14 and 3; or 5 and 3 for %K and %D, respectively.
What Is K and D in Stochastic?
It’s two lines of the indicator that provide signals. %K is referred to as a fast line; %D line is a Simple Moving Average of the %K line.
How Do You Read a Stochastic Oscillator?
A stochastic oscillator is a range-bound indicator that measures market momentum. It determines the periods when the market is overbought and oversold. As a result, it provides perfect entry and exit points.
Is Stochastic a Good Indicator?
As the Stochastic Oscillator is widely used all around the world, it has proven its effectiveness. It was developed at the end of the 1950s but is still applied to different strategies.
Is RSI or Stochastic Better?
It’s wrong to compare RSI and Stochastic indicators. Traders widely use both. However, Stochastic’s signals can be considered more reliable as the tool has two lines which helps determine a more robust signal.
How Is Stochastic Calculated?
As the indicator consists of two lines, you should calculate both lines separately. To calculate %K, subtract the lowest price of 14 previous trading sessions from the current close price. Then subtract the lowest price of the last 14 trading sessions from the highest price of the same period. Divide the first result by the second one. Multiply the last result by 100. To gauge the %D line, subtract the period simple moving average of %K from 3.