Stochastic Oscillator

Guide on Trading a Stochastic Oscillator for Beginners

Stochastic oscillator is one of the technical indicators in the forex market. George Lane created it in the 1950’s to help traders decide when a price could go up or down. Traders usually misinterpret it as offering overbought and oversold signs which is not the case. 

The signs indicate that the strength of a market is high or low. It may contribute to situations that are overbought or oversold before a turnaround happens. Stochastic oscillator is a favourite technological indicator. It is simple to understand and has a high degree of accuracy in signalling the security of a trade.

What is a stochastic oscillator? How does stochastic oscillator work? How do you trade a stochastic oscillator? Or, how do you minimise risk when trading stochastic oscillator? Read on find answers to these and lots of other questions on trading a stochastic oscillator.

What is a Stochastic Oscillator?

A stochastic oscillator refers to an indicator of a momentum that compares a particular ending price to other prices. It is used to generate overbought and oversold trade signals by using 0 to 100 values. The stochastic oscillator is a measure of momentum that uses degrees of support and resistance. It is also valuable for tracing excesses and traded levels.

The stochastic oscillator may also be used for the following:

  • Trade confirmation
  • Divergence number
  • Scalping
  • Trading by intraday
  • Overbought/Oversold confirmation
  • Everyday move of pivot points

What is the Formula for Stochastic Oscillator?

It is determined by deducting the little from the current selling price for the duration. Divide by the total period, and multiply by 100. The formula for determine this is as follows:

%k = 100 [(c – l14)/(h14 – l14)]

Where:

c =       the latest closing price

l14 =    the lowest traded price in the 14 previous trading sessions

h14 =  the highest traded price in the same 14-day period

%k =  the present stochastic predictor value.

What Does Stochastic Oscillator Indicate?

Stochastic oscillator indicates trends between 0 and 100. This renders it a valuable predictor of situations which are overbought and oversold. Traditionally readings in excess of 80 are deemed in the overbought zone, and readings in excess of 20 are excluded. Such, are not necessarily predictive of an imminent reversal. It is rather powerful patterns over a prolonged time will sustain overbought or oversold conditions.

Traders will look to stochastic oscillator improvements for information on potential pattern shifts. Stochastic oscillator chart usually consists of two lines. One representing the oscillator’s real value for each session, and the other reflecting its clear moving average of 3 days.

It is known that the convergence of such two lines is an indication that a turnaround could be in the works. Since it suggests a significant change of momentum from day to day.

Divergence between stochastic oscillator and rising market behaviour is important indicator for reversal. For instance, if a bearish pattern hits a new low the oscillator will indicate a higher level.

How does Stochastic Oscillator Work?

Stochastic oscillator works through uptrend and downtrend:

1. Uptrend

It works when an upward movement in equity values exceeds equivalent or above the previous closing market activity. Stock activity applies to the price rate a commodity is traded at in the regular session.

For instance, if a market opened at $10, exchanged as low as $9.75 and as high as $10.75. It ended for the day at $10.50 the pricing movement or spread will be between $9.75 (the day’s low) and $10.75 (the day’s maximum).

2. Downtrend

It is used during a downtrend to indicate that stocks are expected to stay similar to or below the previous closing point. For example if a market includes a downward trend, the selling price continues to sell near or similar below the day’s trading session’s low point.

Fourteen is the most commonly used amount in arithmetic in time mode. This may reflect days, weeks, or months, based on the technician’s target. Perhaps the chartist needs to look at a whole market. For a long-term view of a market, the chartist will begin by looking at 14 months of the operating cycle of the entire business.

What are the Technical Indicators to Pair a Stochastic Oscillator with?

Moving average crossovers can be used as an adjunct to the stochastic oscillator’s crossover trade signals.

An upward trend is confirmed by a bullish convergence. It happens when a short-term moving average crosses from below and above a long-term moving average. A bearish divergence gives further evidence of a sign of a downtrend.

Limitations of the Moving Average

 
  1. A moving average shows a consistent change in a security’s price over time. But, as each asset has unique price history and volatility levels, there are no uniform rules which can be applied across all markets. 
Yet, moving averages can extend over any amount of time, and this may be troublesome as the pattern can vary based on the time frame used. What seems to be an uptrend using a moving average of 50 days may be part of countermove in a downtrend expressed in the moving average of 200 days.
 
    1. Many analysts contend that moving averages are useless and do not forecast market behavior.
    2. Securities also exhibit a cyclical activity pattern that is not identified by moving averages. This is, if a stock moves up and down a lot, it is impossible that the moving averages reflect any real patterns. Any trend has the aim of forecasting where the price of defence will be in the future. Besides, if a security is not moving in any direction, it does not offer an incentive to take advantage of either buy or short sale.
    3. Another disadvantage of moving averages is that they are a delayed indicator, that is, they never expect a move, but react only to price movements

How do you Trade a Stochastic Oscillator?

To trade a stochastic oscillator you have to understand the measurement of the market which is either overbought or oversold. You should focus on the range of 0 to 100 which is indicated by the stochastic oscillator.  When it is more the 80 (red dotted line), it implies that the stock is overbought.

When the Stochastic lines fall below 20 (the blue dotted line), that indicates the stock could be oversold. You should make your purchase when the stock is oversold and sell it when the on over-brought demand. When you guess that the price will go down then you are totally right because the market was overbought for long.

Most forex traders use stochastic oscillator in many forms. The indicator’s primary objective is to guide you about the market conditions. Bear in mind that Stochastic will linger for long stretches of time above 80 or below 20. It just because the predictor says “overbought” doesn’t mean you can sell blindly. When you see “over-sold” the same thing doesn’t mean you can start purchasing immediately.

How do you set Up Stochastic Oscillator in Your Trade?

The stochastic oscillator default setting is 14 cycles, which can be days, weeks, months or an intraday time span. A 14-period %K will use the new close, the strongest in the last 14 years and the lowest in the last 14 cycles. %D is a basic 3-day movable average of %K. Next to %K this line is plotted to serve as a warning or control thread.

If the price is higher than 200-period moving average (MA) so search for long setups if stochastic is oversold. If the price is below the 200-period moving average (MA) so search for short positions when stochastic becomes overbought.

What are the Trading Conditions for Stochastic Oscillator?

Stochastic oscillator tries to predict tipping points by contrasting a security’s closing price. Prices continue to close just before turning points at the ends of the recent scale. Prices continue to allow higher highs in the case of an uptrend. The settlement price appears to be at the upper end of the exchange average during the period.

The settlement prices continue to retreat from the upper boundary of the range as the momentum starts to slow. It allows the stochastic predictor to decline at or around the final high point. Divergence-convergence is an indicator that market traction is waning and that there could be a turnaround in the making. When rates burst out and keep going, a phenomenon is known as “stochastic rise” happens. It is viewed as a warning to raise the current position or to liquidate the current position if the course is against it.

How can you Minimise Risk when Trading stochastic oscillator?

A free trial on a demo account can help you to minimise risk when trading stochastic oscillator. Instead of entering the market directly and risking your money you should be prepared before taking such a move. Look for a currency pair that shows a marked and lengthy bullish pattern while building a trading strategy. The ideal currency pair has already spent some time in overbought terrain, priced near to a previous resistance point. Look for volume to wane as another sign of bullish fatigue.

You should wait for the price to rise when the stochastic oscillator shifts the indicator down. Although these signals are a good indication of reversal so you should wait until the price confirms the decline before joining. Momentum oscillators are known to throw false signals from time to time.

Conclusion

The stochastic oscillator can be used to identify opportunities that are in harmony with the higher trend. The indicator can also be used to recognise turns close to support or resistance. If a security trade with an oversold stochastic oscillator is close support. Look for a break above 20 to signal an upturn and a positive support check. 

FAQ's

One popular momentum indicator is the stochastic oscillator. Over the duration, it contrasts the price range for a given period with the closing price. It is particularly prone to stock price fluctuations and may oscillate up and down more often than almost any other measure of momentum.

The Stochastic Oscillator is used by beginners and advanced traders alike. It is useful in both trending and ranging markets as it produces a varied range of signals.

The strongest oscillator indicator is pairing basic metrics with the stochastic oscillator. Moving average crossovers can be used as an adjunct to the stochastic oscillator’s crossover trade signals.

The share price is also a measure of a stock’s real worth. Buying stocks is desirable when the stocks are oversold. When a stock is overbought, owners should sell it if they are not emotionally attached to it. We claim they get paid more than it is worth for the product.

The stochastic oscillator’s primary limitation is that it’s known to produce false signals. That is where the predictor produces a selling signal. The market does not immediately carry through, which will ultimately result in a losing trade.

It can happen very often, despite unpredictable market conditions. One approach to deal with this is to use the market pattern as a proxy, in which only signals are taken because they are in the same direction as the trend.