The stochastic oscillator is a momentum indicator that compares the closing price relative to the high-low range over a given period of time. It tracks the speed, often referred to as the momentum, of the price action. It is a general rule that momentum changes direction before price does. Since the Stochastics Indicator is a oscillator, it means that it is range bound. Like the RSI, the stochastics oscillator is therefore mainly used to either identify overbought and oversold market conditions, or spotting divergence in price. Both these indicators provide similar information about market conditions, it is therefore recommended not to use both.
The stochastic indicator is a combination of two lines which oscillate in the range 0-100. These two lines are called the %K and %D line.
- The %K line measures the value of the stochastic its calculation. This is also referred to as the fast moving line.
- The %D line is a n-period exponential moving average (EMA) of the %K line. Which makes it a somewhat slow(er) moving.
To go a little bit more into detail about what these lines indicate, without moving too much into detailed stuff of how these lines are calculated. It’s important to understand what the implications are of these lines and what their values and behavior indicates about current market conditions.
The %K-line measure the relative position of the last closing price against the highest closing price of the total trading range for the selected period. The stochastic oscillator moves in cycles that are often similar to those of the market. A crossing of the %K with the %D signals a potential reverse of a cycle. A crossing of the %K above the %D is considered as being a bullish signal, while a cross below the %D a bearish signal. When the relation between the market and stochastic oscillator cycles is studied on a large sample you’ll notice that the oscillator is often a bit late (also called lagging).
As a trader we’re trying to buy a cycle low in an uptrend and short the cycle high in a downtrend. The problem is how to determine, with high probability, when the market is forming a cycle low or high. There are many tools available to build confluence for high probability cycle turnarounds. Some of these tools are: Moving Averages, Fibonacci retracements, Support & Resistance levels, RSI, MACD, and some more.
Although nothing can truly predict the market, by building a strong case for entry based on confluence, you can have a high probability trade setup. The stochastic oscillator can also be used for finding these cycle highs and lows. Before a market turns off of highs and lows, it often slows down before actually turning. This is called losing momentum or a “momentum shift”. In this way momentum leads price, and therefore, if you see momentum indicators like the stochastic oscillator turning down, while the price is still moving up, or conversely, it gives a signal that price might follow soon.
Besides the %K and %D, there are two other lines displayed in the oscillator. These two horizontal lines represent boundaries of certain ‘overbought’ and ‘oversold’ zones. Usually these lines are placed at the values of 20 and 80, some traders prefer 30-70 though. The use of 30-70 has the advantage of generating more potential trade signals, the other hand of this trade-off is that these signals will likely also generate more false signals. Since the stochastic oscillator measure the level of the close relative to the high-low range over a given period of time, low readings (below 20) indicate price is at its low for that time. On the other hand, high readings (above 80) indicate the opposite, price is at its high.
Some people argue that these overbought and oversold zones also hold value due to mass human psychology. If price has moved up a lot, some market participants will start to take profits. In the oversold zone participants might feel the market has overshot on its move down and start hunting for bargains.
The stochastic oscillator as described above is in the field of Technical Analysis known as the “Fast Stochastic”. This oscillator responds quickly to price changes. Some technical traders prefer the use of the “Slow Stochastics”, which is more likely to generate less false signals. The difference between the Fast and Slow Stochastics comes down to that the %K-line is adjusted twice in the Slow, against the %D where once more is averaged. On your graph the Slow Stochastics often only shows the %D-line. Common input values for fast signals are 5, 3, 3 for %K. For slower signals, but with higher probability, values of 14, 5 and 3 are used.
Simple trading strategy
It is important to realize that overbought readings are not necessarily bearish. Once a currency pair moves in a strong uptrend it might well become overbought and remains overbought for quite some time. Similar situations occur in a strong downtrend. It is therefore important to identify the general trend, as discussed here, and trade in the direction of this bigger trend. Try to find occasional oversold signals in an uptrend, but ignore frequent overbought readings. Similar in a bigger downtrend, focus on occasional overbought signals and ignore frequent oversold readings in such market environments.
Besides the simple trading strategy of buying and selling based on overbought and oversold situations a more advanced, yet powerful, way to use the Stochastic Oscillator is by finding divergences between the oscillator and price action. According to George Lane, who is the one that developed the Stochastics, divergences between price and the oscillator are arguably generating the highest probability signals. Before looking into the two different types of divergences which can occur, there are a few rules which should hold in order for them holding high probability, which are:
- The movement between the tops/bottoms has to point back towards the 50-zone.
- Between two bottoms located in the oversold-zone there has to be a minor top that roughly hits the 40-zone, in order to generate a valid divergence situation.
- Between two tops located in the overbought-zone there has to be a minor bottom that roughly hits the 60-zone, in order to generate a valid divergence situation.
Bullish and Bearish Divergence
A divergence is formed when a new high or low in price is not confirmed by the stochastic oscillator. We speak of a bullish divergence when price forms a lower low, but the stochastic oscillator forms a higher low. This implicates less downside momentum which could foreshadow a reversal. On the other hand we have a bearish divergence, which occurs when price records a higher high, while the stochastic oscillator forms a lower high. This implicates less upside momentum and could therefore also foreshadow a reversal.
Once a divergence takes hold, look for confirmation that signals an actual reversal. Examples of such confirmation can be a support or resistance break on the chart, or the stochastic oscillator breaking below/above the 50-zone/centerline. A break above the centerline signals that prices are trading in the upper half of their high-low range for the given period of time.
Bullish and Bearish Setups
A bull setup is basically the inverse of a bullish divergence as discussed above. The currency pair forms a lower high, while the oscillator forms a higher high. Even though the market doesn’t make a higher high, the higher high in the oscillator shows a strengthening momentum to the upside. A new decline is then expected to be a tradeable setup for a long trade.
Similar is a bear setup based on price divergence. This setup takes place when the market is forming a higher low, while the oscillator shows a lower low. This indicates that even though the market was able to hold its prior low, the lower low on the oscillator shows increasing momentum to the downside. A next advance in price is expected to be a good tradeable setup for a short trade.
The general view is that momentum oscillators are best suited for trading under ranging market conditions. Although this holds true, they can also be used in situations of trending markets, provided that the trend takes on a zigzag format. In such format of pullbacks against the trend, the stochastic oscillator can be used to identify opportunities in harmony with the bigger trend.
When applying a trading strategy based on stochastic oscillators, it is important to always do your own back testing. You should never rely on anyone else his words. By doing your own back testing you also gain confidence in your strategies long run profitability, even if it generates 4 losing trades in a row.