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How to Use the Stochastic Oscillator

One of the most basic and perhaps oldest indicators used by technical analysts is the stochastic oscillator. The stochastic oscillator is an indicator that measures momentum and the strength of a trend. Essentially, its job is to analyze price movement and show how strong the price move is. 

 

The indicator measures the momentum of price, and also shows a slowing of momentum as the momentum of a financial instrument needs to slow down before changing direction. This addresses a weakness in retail trading, the fact that far too few traders pay attention to the importance of the rate of change. 

 

The stochastic oscillator is one of the more common indicators, and it’s one that you will see in a lot of analysis. However, like any other indicator it is simply a tool that you will be using to navigate through the Forex markets, and like any other tool it is needed to be used in the proper settings and situations. 

How to add the stochastic oscillator to Metatrader charts

Adding the stochastic oscillator to the Metatrader platform is very easy. By clicking on the Insert menu, you can pull down the list and click on Indicators, followed by Oscillators, and then Stochastic Oscillator. It's a common indicator, and as such it's built into the platform and there is no need to download from anywhere else.


Adding the Stochastic Oscillator to the Metatrader platform

 

The settings dialog box will pop up, and there are multiple parameters that you can change. The %K period and the %D period settings are available. The %K should be thought of as the slow value of the stochastic indicator and the %D should be thought of as the fast value of the stochastic indicator. It uses a couple of moving averages to measure the overall momentum.

Why does momentum matter?

Think back to your mathematics studies. One of the biggest influences in calculus is the absolute rate of change. The idea is that if the market is in an uptrend, but if the momentum starts to slow down, it can suggest that the market is running out of steam and, therefore, could be ripe for a reversal. In this sense, it can suggest whether or not the market is going to continue, or if it might be over-extended in one direction or the other, and other words overbought or oversold.

Using the indicator to make decisions

The stochastic oscillator has a multitude of uses when it comes to trading Forex. We have already mentioned the most obvious use for the stochastic oscillator: the idea of identifying overbought or oversold conditions. In this scenario, the stochastic oscillator is best used in a range bound market, as it can tell you when to buy and sell in a relatively well defined situation.

When you look at the stochastic oscillator window at the bottom of the chart, you see the two moving averages going back and forth in an up and down pattern. You will notice that there are two lines in the indicator window including the 80 and the 20 level.

 

The area above the 80 level is considered to be overbought, while the area below the 20 level is considered to be oversold.Furthermore, you need to see the moving averages inside the stochastic oscillator to cross in the overbought or oversold areas in order to get a reversal signal. Anything between the two levels is essentially ignored in this scenario.

The Stochastic Oscillator on a chart

 

Looking at the chart, you can see that the stochastic oscillator had several moves back and forth between the 80 and the 20 levels. However, there are only a couple of areas where the indicator either broke into the overbought area or the oversold area and had a cross. You need both of these things to happen in order for it to fire off a signal.

 

In the graphic below, you can see that the signals fired off are color-coded by the arrows, with the red showing an overbought condition and a potential selling opportunity, and the blue showing potential buying opportunities in an oversold condition.

 

It should be noted that using the stochastic oscillator in this way is much more reliable when in a sideways market, preferably between significant support and resistance. This makes the stochastic oscillator truly important, because statistically speaking markets are in some type of consolidation or sideways action more than 70% of the time. In other words, it’s much more common to be in this environment than it is to be out of it. 

Measuring Divergence

Another way that people use the stochastic oscillator in Forex trading is to measure for divergence. The idea is that as with any oscillator, you could see momentum going in a different direction than the overall price. As an example, the momentum could be rising while price is falling or vice versa. If you are in a scenario where price is rising but the momentum is slowing, that means that there is less aggression to the upside and therefore less demand, even as prices press higher. This can be a sign that potential trouble is on its way. 

 

Take a look at the chart just below. You can see that there is a clear uptrend line on the four hour chart for the GBP/AUD pair. As the price was rising, though, notice that the stochastic oscillator made a lower high, which is the opposite of an uptrend. This suggests that the rate of change is slowing down, therefore one would have to be a bit suspicious about the efficacy of the move. 

 

After all, if there is less momentum, it suggests that there are fewer fresh orders coming in to push the market to the upside. Ultimately, you can see that shortly after the diversions with the lower high in the stochastic oscillator, the market broke down below the trend line and then eventually fell from those levels. Divergence can be found in several indicators, essentially the oscillator family. Because of this, using your divergence spotting skills can work in multiple other oscillators as well, as they all essentially work the same in this scenario.

 

divergence in the stochastic oscillator

 

Adding a moving average when using the Stochastic Oscillator

While the stochastic oscillator serves multiple uses, the most important thing that the trader can know is whether or not the appropriate scenario has occured to use this indicator. While the indicator tends to do quite well for sideways markets, it’s important to understand whether or not the market is in fact consolidating. 

 

One of the most common tools used to determine the trend is  the moving average. The moving average simply displays on a chart what the average price of a certain amount of candlesticks is. For example, if you have a 50 day moving average, it plots the average price of the previous 50 candlesticks. The idea is that if the moving average is essentially flat, that shows that the market has been very quiet as of late, and in a range-bound scenario. (After all, even if the moving average is relatively flat, there still will be fluctuation in the price, creating a range.) At this point, knowing whether the market is overbought or oversold can be very useful.

 

However, if the market is in fact trending, by its very definition it’s hard to be overbought or oversold, at least using the standard settings for the stochastic oscillator. This is because the stochastic oscillator tends to use low settings, meaning that it’s an  extraordinarily sensitive indicator, and perhaps not as slow to change as  some other ones, like the Relative Strength Index or the Commodity Channel Index, two of the most common oscillators used by trend traders. In an uptrend or downtrend that shows determination, the stochastic oscillator can fire off several false signals due to the fact that it’s so quick to expand and contract. 

 

Take a look at the chart below. You can see that there is a blue rectangle where the market has been sideways and therefore a good area to look for signals based upon the stochastic oscillator reaching the overbought or oversold condition and of course having the crossover. On the other hand, you can see that later on the market started to trend as shown at the red rectangle. At that point, several false signals were fired off, showing that the stochastic oscillator is not the correct indicator for the job, although it can still be used for spotting divergence.

 

Using Stochastic Oscillator with a moving average

 

Some thoughts on the Stochastic Oscillator in Forex trading

There are a host of things to think about when using the stochastic oscillator in Forex trading. The first thing you need to understand is whether it’s appropriate for the trading environment that you are working in. This is when adding the moving average can help, making sure that you are using the right tool in your toolbox for the job at hand.

That being said, the stochastic oscillator is much less useful with a strong trend. It can be used, however, to spot divergence, but you should keep in mind that divergence is probably best used on a longer-term timeframe such as the four-hour chart or above. 


Ultimately, one of the great things about the stochastic oscillator  is the fact that it’s such an old indicator that you can be sure that plenty of other traders out there will be paying attention to the same signals. In a sense, this is part of what makes the stochastic oscillator work.

 

While the increase in algorithmic trading would have got traders thinking that some of these old indicators aren’t being used, the exact opposite is true. Because of this, some of the more commonly used indicators will more often than not be part of an algorithmic program to fire off trades. In other words, the stochastic oscillator will continue to be used heavily by the trading community.

 

Some highlights:

  • The stochastic oscillator allows traders to see the overbought or oversold condition of a market

  • The stochastic oscillator is used for consolidation ranges

  • The stochastic oscillator spots divergence between momentum and price

  • The stochastic oscillator is commonly used, therefore has a certain appeal 

 

Ultimately, if you are going to use the stochastic oscillator it is best to match it up with another indicator in order to determine trend. At the very least, you should be aware of any trendline analysis that will let you know whether or not you are in the right type of market conditions. 
If you are, stochastic oscillator becomes a very useful tool. However, if you are in an extreme trend, it can be very expensive to follow. For this reason, it’s rare to see analysis with a stochastic oscillator not accompanied by at least one other indicator. 

 

If you are going to use it, start out with a demo account and test how it behaves with your system. The stochastic oscillator is a great addition to your toolbox, but it’s not a system in and of itself so therefore it should not be thought of in those parameters.

 

It’s quite common for traders to use a stochastic oscillator when the time is right, but switch to something like the Relative Strength Index as an oscillator when we see the market jump out of consolidation. Quite often, traders will simply go back and forth between two oscillators, depending on what the moving averages or a trendline is telling them.

 

While that’s true, there are other settings that traders can use but you should be aware of the fact that if you extend the settings further out, it gets rid of the sensitive and reactive nature of the stochastic oscillator, which makes it such a great range bound indicator. 

 

Knowing your situation, and the limitations of this tool, will greatly increase your success.

 

 

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