What Is The Stochastic Oscillator & How To Trade With It

George Lane, president of Investment Educators Corporation, developed the Stochastic Oscillator indicator in 1950s. All calculations were manually performed, and a group of traders had formed formulas for oscillators, sequentially giving them the names % A, % B, % C, etc. Only three were operational: % K, % D and% R.

What is the Stochastic Oscillator indicator?

The % K and % D are the first two curves known as stochastic Lane, and the last (% R) is named after Larry Williams. Another variant of the origin of the names of the stochastic indicator lines: % K – from the name Kelly (middle name of George Lane), % D – from the word deviation.

A stochastic oscillator is an indicator of the rate of change of momentum of a price. Stochastic estimates the speed of the market by determining the relative position of closing prices in the range between the maximum and minimum for a specific number of days. The indicator takes the current price and subtracts the price from it, which was a few days ago.

Suppose that trading on the GBPUSD pair closed today at the level of 1.3050, and 10 days ago – at 1.2900. In this case, the value of the Oscillator would be 0.0050. The course is repeated daily, and the data is plotted on a graph.

Like, a 14-day oscillator takes into account the position of closing prices within the entire range between the maximum and minimum for the previous 14 days. Stochastic expresses the relationship between the closing price and the high-low range as a percentage from zero to 100.

Stochastic Oscillator Indicator
Stochastic Oscillator Indicator

A stochastic oscillator of 70 or higher indicates that the closing price is near the upper limit of the range; stochastics of 30 or lower means that the closing price is near the lower end of the range.

Simply said, if you see a 50% indicator, then this means that the closing price lies precisely in the mid between the top and bottom. If the indicator is 75%, it would be at 75% of the daily range or closer to the maximum than to the minimum.

Thus, if the market closes at a maximum daily range, then you can only see a 100% indicator on stochastics. The main idea is that if the price stays near the top of the daily range, then it is bullish, if at the bottom, then it is bearish.

How to trade with the Stochastic Oscillator indicator?

Stochastic Oscillator consists of two lines: fast, called% K, and slow, called% D. The second is the most significant since its dynamics and can be used to judge the most critical changes in the market. Stochastic Oscillator analysis determines the location of the closing price relative to the price range for a specified period. The most common calculation period for this Oscillator is five days.

A short period of stochastic Oscillator allows you to detect more turning points, and a more extended period – to identify the most critical turning points.

Stochastic Oscillator allows you to set in percentage terms (0 – 100%) the place of the last closing price in the general price range for a particular selected period. If the obtained value is above 80, then the closing price is near the upper limit of the range, if below 20, then, respectively near the lower limit of the range.

Curve K is depicted on the graphs by a continuous line, and the slower curve D by a dashed line.

When making trades on forex using the strategy for the Stochastic Oscillator and tactics for the corresponding execution of transactions, which are based on a stochastic indicator, the following rules can be observed:

  • A buy deal is possible when the chart curve (you can use either% K or% D) is below the indicated level (as a rule, they set the level to 20%), and then starts rising. Accordingly, a sell deal is possible if the curve, first being above the designated level (80%), crosses it down.
  • You could buy an asset if the% K curve is above the% D curve, and you could sell if the% K curve is below the% D curve.
  • There are times when the price sets new highs, and the stochastic indicator does not overcome its previous peaks. In this case, you can expect a quick trend change in the downward direction.
  • Breaching the 80% level can be interpreted as a signal of a possible halt in price growth, or even of a trend reversal. Breaching the level of 20% in the lower direction indicates a slowdown in the fall of prices and the possible emergence of an uptrend.

Stochastic Oscillator Trading Strategy

Stochastic Oscillator forms three types of forex trading signals:

  • divergence
  • stochastic oscillator lines level
  • the direction of stochastic oscillator lines.

Bearish divergence (divergence) occurs when curve D is above 80 and forms two peaks, and prices continue to rise.

Stochastic Oscillator Bearish Divergence
Stochastic Oscillator Bearish Divergence

Bullish divergence (divergence) is formed when the D curve is below 20 and forms a double rising base, and prices continue to fall or standstill.

Stochastic Oscillator Bullish Divergence
Stochastic Oscillator Bullish Divergence

A buy signal is generated when the stochastic Oscillator (% K or% D) first falls below the level 20, and then rises above it. If the stochastic line% K of the Oscillator rises above the% D line, a buy signal is also generated.

Stochastic Trading Strategy - Buy Signal
Stochastic Trading Strategy – Buy Signal

A sell signal is formed when the stochastic Oscillator first rises above a certain level (usually 80) and then falls below it. If the stochastic line% K of the Oscillator falls below the% D line, a sell signal is also generated.

Stochastic Trading Strategy - Sell Signal
Stochastic Trading Strategy – Sell Signal

Stochastic Oscillator conclusion

Stochastic is indeed a popular forex trading indicator but like any other indicators, it needs to be tested so that it can be correctly used. Since this is an oscillator, therefore, you may use any volatility or trend indicator with the setup to add further confirmation in your trade setups.

If you would like to practice trading with the Stochastic Oscillator, you can open an account with a forex broker and download a trading platform. If you are looking for a forex broker, you may wish to view my best forex brokers for some inspiration.

Happy trading!