Stochastic Oscillator: a Step by Step guide to use it

In Technical analysis you can use many indicators to read a chart. Stochastic is one of these

In trading, market participants use two types of analysis. In fundamental analysis, they look at market news, economic, and earnings data to predict how a currency pair or any other asset will move.

In technical analysis, they look at charts and use various technical indicators to help them predict.

These technical indicators are divided into:

  • Trend following
  • Volumes
  • Bill Williams
  • Oscillators

In this article, we will look at an indicator known as Stochastic oscillator, which is one of the most popular indicators used in the market.

What is Stochastic Oscillator?

Stochastic Oscillator is an indicator that was developed by George Lane, who was a well-known trader in the 1950s. The indicator is used to show the direction of the close relative to the high-low range of a certain duration.

Unlike other types of indicators that follow volumes and price, the Stochastic Oscillator is unique because it follows the momentum of the price. This is because momentum tends to change before the price.

As such, the indicator can be used to show when reversals will happen.

The Stochastic Oscillator is calculated using a very simple method. First, you need to find the %K.

This is calculated using the formula below:

(Current Close – Lowest Low) / (Highest High – Lowest Low) X 100

You then calculated %D. This is calculated by calculating the 3-day Simple Moving Average of %K.

stochastic oscillators formula

The stochastic oscillators formula

The lowest low and highest high are the lowest and highest levels during the specific period. In most trading platforms like MetaTrader, the default period is usually 14. However, you can tweak this period to match your trading style.

Also, as with many traders, you don’t need to know how to calculate these figures. You just need to know how to apply them.

Another thing you need to know is that there are three types of Stochastic Oscillators. These are fast, slow, and full oscillator.

The Fast oscillator is based on the original computation suggested by Lane. However, the %K calculated can be a bit unreliable.

The slow oscillator removes this by removing then emphasis because the %K in the slow stochastic oscillator is equal to the %D in the fast oscillator.

How does Stochastic Oscillator work

When you put a stochastic oscillator on a chart, you will see two lines of different colors, the main and signal lines. You will also see two main levels of 20 and 80. Ideally, when the two lines are below 20, the pair is said to be oversold and when the lines are above 80, it is said to be overbought.

One way that traders use Stochastic Oscillator is to buy when the two lines intersect below the oversold level. They ride the upward trend until the two lines intersect above the overbought level. This is shown in the chart below.

stochastic oscillators sample

As shown above, a sell signal emerged when the two lines intersected while being above the overbought level. A buy signal emerged when the same happened in the opposite direction.

There are several things you need to know. First, the Stochastic Oscillator is famous for giving false signals. Therefore, it is always good to combine it with other technical indicators and charting tools like Fibonacci Retracement and Pitchfork.

Second, the indicator should only be used when a financial asset is trending. When it is used in ranging markets, it can give false signals.

External useful Resoruces

  • Stochastic Oscillator Definition – Investopedia
  • How to Use the Stochastic Indicator for Forex Trading – Babypips

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