How to use Stochastic Oscillator in Forex Trading
“Stochastics measures the momentum of price. If you visualize a rocket going up in the air – before it can turn down, it must slow down. Momentum always changes direction before price.” – George Lane, the developer of the Stochastic indicator.
What is the Stochastic indicator?
The STOCHASTIC indicator shows us information about momentum and trend strength. As we will see shortly, the indicator analyses price movements and tells us how fast and how strong the price moves.
What is momentum?
Before we get into using the Stochastic oscillator, we should be clear about what momentum actually is.
Investopedia defines momentum as “The rate of acceleration of the price of a security.”
We are always a fan of going into how an indicator analyzes price and without getting too deep into mathematics, this is how the indicator analyzes price:
The stochastic indicator analyzes a price range over a specific time period or price candles; typical settings for the Stochastic is 14 periods/price candles. This means that the Stochastic indicator takes the absolute high and the absolute low of that period and compares it to the closing price.
How Stochastic is Calculated
The Formula For The Stochastic Oscillator Is
Where:
C = the most recent closing price;
L14 = the lowest price traded of the 14 previous trading sessions;
H14 = the highest price traded during the same 14-day period; And
%K = the current value of the stochastic indicator.
%K is referred to sometimes as the slow stochastic indicator. The "fast" stochastic indicator is taken as %D = 3-period moving average of %K.
The general theory serving as the foundation for this forex indicator is that in a market trending upward, prices will close near the high, and in a market trending downward, prices close near the low. Transaction signals are created when the %K crosses through a three-period moving average, which is called the %D.
When your Stochastic is at a high value, it means that price closed near the top of the range over a certain time period or a number of price candles.
Conversely, a low Stochastic value indicates that the momentum to the downside is strong.
Continue reading for more information or start playing around in a risk-free demo account and notice how stochastic oscillator works in real market conditions.
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Overbought vs Oversold
The misinterpretation of overbought and oversold is one of the biggest problems and faults in forex trading or stock trading. We’ll now take a look at those expressions and learn why there is nothing like overbought or oversold.
The Stochastic indicator does not show oversold or overbought prices. It shows momentum.
Generally, traders would say that a Stochastic over 80 means that the price is overbought and when the Stochastic is below 20, the price is considered oversold. And what traders then mean is that an oversold market has a high chance of going down and vice versa. This is wrong and very dangerous!
As we have seen above, when the Stochastic is above 80 it means that the trend is strong and not, that it is overbought and likely to reverse. A high Stochastic means that the price is able to close near the top and it keeps pushing higher. A trend where the Stochastic stays above 80 for a long time signals that momentum is high and not that you should get ready to short the market.
The image below shows the behavior of the Stochastic within a long uptrend and a downtrend. In both cases, the Stochastic entered “overbought” (above 80), “oversold” (below 20) and stayed there for quite some time, while the trends kept ongoing. Again, the belief that the Stochastic shows oversold/overbought is wrong and you will quickly run into problems when you trade this way. A high Stochastic value shows that the trend has strong momentum and NOT that it is overbought.
The Stochastic Oscillator Signals
Finally, we want to provide the most common trading signals and ways how traders are using the Stochastic indicator:
- Breakout trading: When you see that the Stochastic is suddenly accelerating into one direction and the two Stochastic bands are widening, then it can signal the start of a new trend. If you can also spot a breakout out of sideways range, even better.
- Trend following: As long as the Stochastic keeps crossed in one direction, it shows that the trend is still valid.
- Strong trends: When the Stochastic is in the oversold/overbought area, don’t fight the trend but try to hold on to your trades and stick with the trend.
- Trend reversals: When the Stochastic is changing the direction and leaves the overbought/oversold areas, it can foreshadow a reversal. As we’ll see, we can also combine the Stochastic with a moving average or trendlines nicely.
- Important: when we look for a bullish reversal, we need to see the green Stochastic line to get above the red one and leave the overbought-oversold area.
- Divergences: As with every momentum indicator, divergences can also be a very important signal here to show potential trend reversals, or at least the end of a trend.
Combining the Stochastic with other tools
As with any other trading concept or tool, you should not use the Stochastic indicator by itself. To receive meaningful signals and improve the quality of your trades, you can combine the Stochastic indicator with those 3 tools:
- Moving averages: Moving average can be a great addition here and they act as filters for your signals. Always trade in the direction of your moving averages and as long as the price is above the moving average, only look for longs – and vice versa.
- Price formations: As a breakout or reversal trader, you should look for wedges, triangles, and rectangles. When price breaks such a formation with an accelerating Stochastic, it can potentially signal a successful breakout.
- Trendline: Especially Stochastic divergence or Stochastic reversal can be traded nicely with trendlines. You need to find an established trend with a valid trendline and then wait for the price to break it with the confirmation of your Stochastic.
Setting up Stochastic Oscillator in MetaTrader 4/5
This section shows you how to set up Stochastic Oscillator in MetaTrader. It assumes that you have opened a chart.
Add the Stochastic Oscillators and set the parameters of this indicator
- Click Insert and move your mouse over Indicators and Trend
- Click Stochastic Oscillator
Setting the common parameters
After you have completed the step above, the settings menu appears.
Most indicators can be controlled by several common parameters.
There are two types of parameters:
- Calculations of the indicator: e.g. the number of periods used for the Bollinger bands (you do not need to worry too much about this in the beginning)
- Visuals of an indicator: e.g. how it will look, the color and thickness of the lines, etc.
Changing parameters at a later time
To change the settings of the indicator directly on the chart at a later date:
- Right-click the Stochastic Oscillator (you will have to be exact on the line of the indicator to get the menu seen below)
- Choose Bands(5,3,3) Properties – The (5,3,3) is the respective parameter (%K period, %D period and Slow) and can differ, depending on your choice when setting the parameters.
The parameter menu appears again where you can change the indicator.
To delete the Stochastic Oscillator:
- Right-click the indicator that you want to delete (you will have to be exact on the line of the indicator to get the menu shown below).
- Click Delete Indicator.
The Stochastic Oscillator will disappear from your chart.
Understanding what is a stochastic oscillator and how it works is important, but if you want some help, MetaTrader 5 AM Broker offers a useful Oscillators toolkit and our trainers can provide you the right guidance.
Play around in a demo account and notice how stochastic oscillators can make you serious money. Alternative, use an Expert Advisor Builder and generate automated trading strategies using best stochastic oscillator settings in a few clicks, without writing codes.
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