Trading crossovers of the stochastic oscillator can be a simple yet effective forex trading strategy for beginners. A crossover signal occurs when both Stochastic lines cross in the overbought or oversold region. Even the more experienced forex traders keep an eye on the stochastic crossover which can increase its reliability. However, I find that it works best when combined with other forms of market analysis in order to confirm the buy and sell signals that the stochastic crossover generates.
What is the stochastic oscillator?
The stochastic oscillator is a popular forex trading indicator for conducting technical analysis. The indicator provides buy and sell signals for traders to enter or exit positions based on momentum.
It is a very diverse trading tool that can be used to find entry points in range bound and trending markets. I use it to spot overbought or oversold market conditions, to identify new market trends and measure the momentum of a currency pair.
The Stochastic Oscillator ranges between 0 and 100. A reading of 0 means that the latest closing price is equal to the lowest price of the price range over the chosen time period. A reading of 100 means that the latest closing price is equal to the highest price recorded for the price range over the chosen time period.
How to trade the stochastic crossover strategy
The stochastic crossover is popular strategy used by forex traders. A crossover occurs when the fast stochastic (%K line) intersects the slow stochastic (%D line).
A bearish stochastic crossover is when %K fast moves below %D slow. In contrast, bullish stochastic crossover is when %K fast moves above %D slow. Bearish/bullish stochastic crossovers act as confirmations to bearish/bullish divergence.
Because the %K line reacts more quickly to market changes it oscillates at a faster rate than the %D line. Under certain conditions, it can catch up to, and cross over the %D line.
The crossover can be even more powerful when it happens in an overbought or oversold region on the stochastic. You can take the crossover signal as it is, but I would personally confirm trades with additional technical indicators.
Some of the best technical indicators to complement the stochastic oscillator are moving average crossovers and other momentum oscillators including the relative strength index (RSI) and moving average convergence divergence (MACD). Moving average crossovers can be used as a complement to crossover trading signals given by the stochastic oscillator.
Buy signal
When an increasing %K line crosses above the %D line in an oversold region, it is generating a buy signal. You can wait for a bar to close to confirm the stochastic crossover and then look for further confirmation with price action analysis and other indicators.
On this EUR/USD 1-hour chart, you can see that there was a stochastic crossover with settings 5,3,3 near the extreme oversold 20 level. This suggests a pending buy opportunity. The entry was confirmed with price being above the 21-period moving average and a bullish inverse hammer candlestick pattern. The stop loss could have been placed below the moving average whilst the exit point could have been price crossing back on the over side of the moving average.
Sell signal
When a decreasing %K line crosses below the %D line in an overbought region, it is generating a buy signal. Again, you can wait for a bar to close to confirm the stochastic cross and then look for additional confirmation with price action analysis and other indicators.
You can see in this EUR/USD 1-hour chart that the stochastic with settings 5,3,3 crossed over above the 80 extreme level which was our first alert for a possible short trade. This was confirmed with price opening below the 21-period moving average and a bearish engulfing candlestick pattern. The moving average could have been a good place to put the initial stop loss on this particular position.
Which stochastic settings are best?
80 and 20 are the most common extreme levels used for overbought/sold signals, but can also be modified as required. I like to stick to the default stochastic setting of 5,3,3 as I find this works well.
The lower you set the stochastic settings, the more signals you will get. However, you may find that this causes a lot of false signals. If you increase the period, the stochastic signals will be less frequent but could be more reliable.
What time frame is best for the stochastic crossover?
I think that the 1-hour charts and above help to filter out a lot of the noise that you can see on the lower chart timeframes. Yes, you can use the stochastic crossover strategy on any timeframe, but you may need to be extra diligent when using it for trading on the lower chart timeframes such as the 1-minute, 5-minute and 15-minute charts.
If you don’t have much time to dedicate to trading, then you might want to consider the 4-hour and daily charts. There will be less signals but they can be stronger as they include more data regarding the prices of a currency pair. Not to mention, it will only take you a few minutes each day to check for stochastic crossover signals.
Stochastic crossover strategy Pros & Cons
Pros
- Identify overbought and oversold currency pairs
- Can be used to spot entry and exit points
- Confirm buy/sell signals from other indicators
- Can be used on any chart timeframe and trading instrument
- Very easy to interpret the stochastic crossover signals
- Fully customisable settings for all trading styles
- Stochastic indicator is free on most forex platforms
Cons
- Requires additional confirmation
- Lots of false signals, especially on lower timeframes
- Can take some practice to master
Conclusion: does the stochastic crossover strategy work?
Yes, the stochastic crossover is a very powerful strategy but the signals should be confirmed with other forms of market analysis. Also, any forex strategy is only as good as the trader using it. This means that you should have good money management in place and ensure that you have a trading plan which you stick to.
It is not uncommon to see 2 traders get completely different results using the same forex system, simply because they have different stop loss and take profit levels. I would want to cut my losing trades short and let the winners run. This will prevent one bad trade wiping out a run of consecutive winners and help to ensure a favourable risk to reward ratio.
You can practice trading the stochastic crossover strategy on a forex demo account. This can be a good way to get a feel for how it works and build your confidence. Once you start seeing some good results with it, you might then consider switching to a live account. You can get a free demo account from most forex brokers, including IC Markets who have tight spreads, quick execution speeds and excellent customer support.
Self-confessed Forex Geek spending my days researching and testing everything forex related. I have many years of experience in the forex industry having reviewed thousands of forex robots, brokers, strategies, courses and more. I share my knowledge with you for free to help you learn more about the crazy world of forex trading! Read more about me.
