Stochastic oscillator (stochastic indicator) is one of the most popular technical indicators, it is included in 80% of all existing trading strategies.
This tool is used by many beginners and experienced pros to determine trend reversal points.
How to set up the stochastic indicator for profitable trading and how to choose the right strategy – we will talk about this below.
Download the Stochastic indicator.
What is the Stochastic indicator
Before proceeding to the analysis of trading strategies, you need to understand what this indicator is. Without knowing its formula and algorithms, you will not get a full analysis. You need to learn to feel the market. And not just follow the signals and recommendations of computer programs.
Stochastic indicator (or Stochastic oscillator) is a technical analysis indicator that displays the percentage of the closing price and maximum extremes for a specific period of time.
In other words, Stochastic allows you to determine when a trend reversal will begin and tell you when to open a deal.
Stochastic is universal, it can be used for both currency pairs and stocks. Therefore, it is widely used both in Forex and in the stock market and in futures trading. Even in the cryptocurrency market, you can use this indicator.
Stochastic is able to calculate the following moments:
- Local highs and lows of the price.
- The origin and end of the trend or the beginning of a correction.
- Convergence and divergence.
Indicator description with examples
Stochastic is based on a simple pattern, in which the price is fixed at the local maximum level in a bullish trend, and at the minimum level in a bearish one.
History of creation
This indicator was created in the 50s of the last century by George lane.
It was based on Momentum, that is, how much the amplitude of the price changes. Momentum is calculated as the difference between the current price and the price that was a certain time ago. According to the Creator, when the Momentum changes, then the price changes.
Now calculations occur automatically as soon as you put the indicator on the chart in the working terminal. The Creator himself – George lane calculated everything manually.
So, The stochastic indicator is represented by two lines, which are calculated as follows:
- Line %K = (current closing Price-Local minimum for the selected time period) / (Local maximum for the selected time period – Local minimum for the same time period) * 100.
- %D line-classic SMA (simple moving average) indicator for a certain period of time %K.
In other words there are two lines on the chart:
Visually, they move roughly next to each other on a scale of 0 to 100. %K displays the closing price in relation to the specified time period, and %D-the classic MA.
A full Fledged stochastic indicator is built on the basis of 3 parameters:
- The smoothing factor;
- The period for the %K;
- The period to determine the %D.
However, in its modern form, the indicator is an averaged instrument between the first two parameters.
How to apply Stochastic
Two lines move in the range from 0 to 100, but for full performance, you also need to consider overbought and oversold:
- Oversold – from 0 to 20.
- Overbought – from 80 to 100.
These levels were recommended by George lane. However, the trader has the right to change them, adjusting them to his strategy.
Since by its definition Stochastic is an oscillator, it, in contrast to the classical instruments (Moving Averages, Bollinger Waves, etc.), sinning with the delay of signals, demonstrates leading indicators. For this, it is loved by experienced traders.
It is believed that when the price hit the critical zone, it is a preliminary signal to change the trend, but not the final one. If the trend is strong, Stochastic lines may remain in critical overbought / oversold zones for a long time. And only the exit from these zones with the subsequent trend change will be a signal to sell or buy, respectively.
Setting the Stochastic indicator
Most of the trading strategies are based on the basic settings of this indicator. Beginners are not recommended to change them, as they are embedded in the program by smart people since the creation of the indicator. You should change the settings when you have already gained experience and will be ready to change these parameters, i.e. you will clearly understand what is responsible for what.
Stochastic settings are quite complex, so in order not to get confused, you should know that there are 3 versions:
Usually Stochastic parameters are indicated by three digits (for example, 5:3:3), with the first and last digits referring to all versions, the second – only the Full one.
Depending on the platform on which the analysis is performed (Metatrade or Live Chart), the settings panel may differ. Below we will look at the MOST common and popular MT4 terminal.
By clicking on settings, you will see 4 tabs:
The options tab is the most significant. It is here that the period values are set – the most important setting of the indicator, it depends on how often and accurately trading signals will be generated for trades.
- %K – number of periods.
- %D-moving average period.
- Method – type of moving average (simple, exponential, weighted).
- Deceleration – the level of smoothing (because in simple words-the sensitivity of the indicator).
- Prices – which prices will be taken into account (open, close, minimum or maximum values).
The "Colors" tab allows you to select the colors of the tool lines on the chart that are suitable for you. Tab "Levels" - set the boundaries of oversold and overbought zones. The default is 20 and 80, respectively. George lane recommended these levels. But you can install others. For example, some change them to 10 and 90 to reduce false signals or increase the number of trades.
The Stochastic indicator is ideal for any timeframe and any trading assets. But, depending on the selected time period, you should change the settings.
The basic parameters are 5:3:3. For short-term trading (on 5-15 minute charts), you can change the first digit to 7.
For 1 – 4 hour H1 H4, as well as for daily timeframes, you should set the period for the %K line at about 9-21. But for the weekly chart, Stochastic 21:7:7 is perfect.
The smaller the period parameters, the more signals the indicator generates. Important! At the same time, the number of false signals increases.
The screenshots clearly show the difference between The stochastic readings at different settings: 5:3:3, 14:3:3 and 21: 7: 7. The third settings will respond only to the strongest fluctuations, that is, they will smooth out market noise, giving clearer and more reliable signals.
What timeframe to choose? Everyone decides for himself. There are many successful trading strategies for different time intervals. The Creator of the Stochastic oscillator George lane while creating his masterpiece used the daily and weekly charts.
How to use Stochastic and its signals
This indicator is able to generate various trading signals. The most common ones are:
- The intersection of the %K and %D lines between each other (it is important in which zone this intersection occurred).
- Entering critical oversold and overbought zones.
- Crossing the %K line with the 20 and 80 lines is an exit from the critical overbought and oversold zones. Trades on the increase are opened after the candle closes, where the %K line crossed the level 20 in the upward direction. A down trade is opened when line 80 crosses in the top-down direction. That is, when the price leaves the overbought zone, the upward trend with a high probability ends, after which sellers will come to the market, which will lead to a change of trend to a downward one.
- The intersection of the %K and %D lines between each other. Pay attention only to those crossings that occurred in the oversold or overbought zone. Otherwise, false signals caused by market noise will be taken into account.
Convergence and divergence
Divergence is a discrepancy between the indicator readings and what is seen on the chart.
For example, the price updates its maximum, and the Stochastic at this point falls, updating the lows.
When such a situation occurs, it is assumed that The stochastic indicator is right, i.e. the price will really turn down.
In order to avoid mistakes, experienced traders are advised to combine Stochastic with any trend indicator that will be used exclusively as a filter. For example, Stochastic plus Simple moving average.
You can use One stochastic indicator, but it is best to combine it with others to filter false signals, which will improve the quality of trading.
A popular and time-tested strategy. It is recommended for medium-term trading (on four-hour and daily timeframes H4 and D1).
The main task of this strategy is to open two Stochastic indicators on the chart at the same time, but with different settings.
The first (main) indicator should be set to 21:9:9, the second (auxiliary) - 9: 3: 3.
The deal is concluded only when the readings of two indicators coincide at the same time.
Stochastic, mA Moving Average and Relative Strength Index RSI
Another of the most popular strategies, which is universal and can be used on different timeframes (except for 1-5 minutes).
With this strategy, the indicators should be configured as follows:
- Stochastic: 14: 3: 3.
- The RSI period 14, the critical levels: 70, 50 and 30.
- Add Exponential averages with a period of 5 and 10 to the chart.
A buy trade is opened when the following signals coincide at the same time:
- Both Stochastic lines are looking up, but have not reached the overbought zone.
- The RSI line is located above the midpoint of 50.
- EMA5 crosses EMA10 in the direction from the bottom up.
A sell trade is opened when the following signals coincide at the same time:
- Both Stochastic lines are looking down, but have not reached the oversold zone.
- The RSI line is below the midpoint of 50.
- EMA5 crosses EMA10 in the direction from top to bottom.
Stochastic and Bollinger Bands
Bollinger bands are an independent indicator that helps to get high profits in Forex. Its main task is to determine the price movement corridor. It is considered that 80% of the time the price is within this corridor. Thus, when the price approaches the lower border of the corridor, it is highly likely that it will rebound from it as a support level and go up. And, conversely, when approaching the upper border, the price will push off and go down.
In order to avoid false signals, it is necessary that these moments coincide with the simultaneous intersection of Stochastic lines in the critical oversold and overbought zones.
Stochastic and MACD
The MACD indicator is very much loved by professional traders because it combines both an oscillator and a trend indicator. It is successfully used both in the trend and in the flat.
In combination with Stochastic, trading efficiency increases.
In this strategy, the MACD indicator helps to determine the trend, and the Stochastic indicator helps to determine the entry points.
When the MACD chart is above zero, the market is dominated by an uptrend, below-a downtrend. Crossing the zero line from the bottom up means changing the trend from bearish to bullish and Vice versa.
The Stochastic indicator does not work well on a flat trend, that is, when there is no obvious trend. To filter false signals, it is better to use Stochastic with other trend indicators.
Do not stop there, continue to improve your knowledge of technical analysis. It is not limited to indicators only. Candlestick and graphical analyses are effective. Learn how to build support and resistance levels, learn the Price Action technique, learn the reversal combinations of Japanese candlesticks.
Be sure to use a multi-timeframe approach, that is, check the signals on different timeframes.
Stochastic by its nature is an oscillator indicator, so it works on the principle of wave theory and impulse market movement. When used correctly, it can be a powerful tool for generating a stable income.
But it is important to set the settings correctly. Beginners should avoid short-term trading, as due to the large market noise Stochastic will give a lot of false signals.
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