As a trader, you must have found yourself in this situation…
You looked at a chart and realized that the stochastic oscillator has been overbought.
What clicked into your mind is that the market is about to reverse.
So, you immediately went shot!
And then to your surprise, the market stalled !
It paused for a while!
Next, it moved even higher!
So, you were kicked out of a trade from which you could have made profit.
Well, don’t worry. It has happened to many traders.
After reading this article, it will never happen to you again!
The article guides you through stochastic indicator trading.
What is the Stochastic Oscillator?
The stochastic oscillator is an indicator that helps traders know where the price is ending.
The stochastic oscillator measures the momentum of price.
Momentum is the rate at which the price of a security accelerates.
If you throw a stone upwards into the air, it must slow down before it turns direction.
Similarly, momentum changes direction before price.
So, the stochastic oscillator is an indicator that measures the momentum in markets.
With this indicator, you can know the strength of a trend and analyze price movements to know how strong and fast the price moves.
If you love maths, here is the formula to calculate the stochastic indicator…
%K = (Current Close – Lowest Low) / (Highest High – Lowest Low) * 100
%D = 3-day SMA of %K
Lowest Low is the lowest low for a look-back of the previous 14 trading sessions
Highest High is the highest high for the look-back of the previous 14 trading sessions
%K is the most recent market rate for the currency pair. It is multiplied by 100 to move the decimal point to two places
%D = 3-day is a simple moving average of %K.
A High Stochastic Number
Consider the following example…
The above graphic shows that the low was at $150, the high at $200 (a range of 50) and the price closed at $180.
From the calculation, the value of the stochastic indicator is 60%, meaning that the price only closed 40% (100%-60%) from the absolute top.
From the above calculation, you can tell that the stochastic was at a high value. This means that the price closed near the top of the range over a particular period of time or number of price candles.
A Low Stochastic Number
We can also have a low stochastic number. It’s an indication of a strong momentum to the downside. Consider the following example :
The above gives us a stochastic value of 10%. This means that the price only closed 10% above the low of the range. This means that the downside momentum is very strong.
Characteristics of the Stochastic Oscillator
Below are the major characteristics of the stochastic oscillator…
#1: It is a lagging indicator
Most indicators are lagging indicators. Stochastics are also lagging indicators.
If you catch this concept well before beginning your trades, you’ll stay ahead of other traders!
Important point to note:
The stochastic oscillator is price-driven, it doesn’t drive the price.
Trading platforms create indicators based on the price data that they receive.
If the price is not recorded in the trading software, the indicator cannot be populated.
The price has four dimensions, Open, Close, High, Low.
All indicators are simply different versions of the same data source.
All the lagging indicators that you’re currently using cannot be used to predict the future price.
The reason is that the price is determined by external factors rather than the indicators.
There are many lagging indicators, but stochastic indicators are the most popular among traders.
#2: Oversold/Overbought levels are an indication of a strong trend, not a reversal
As we are going to discuss, some traders have a wrong belief that stochastic points to overbought or oversold levels signal a reversal.
However, the stochastic oscillator normally signals an uptrend above 80 or a downward continuation below 20.
From the above chart, the stochastic entered both overbought and oversold positions and stayed there for long.
No trader should follow the overbought or oversold rule blindly.
If you try to enter long positions each time the trade goes below 20, you will simply be ruining your trading account.
Also, an oversold level should be considered as an indication of a strong trend, not a reverse signal.
#3: Use the stochastic oscillator with other leading indicators
Traders use technical indicators to perform technical analysis and gain useful information about trades.
Some traders rely on a single indicator to make buy or sell decisions. This is not good!
No Forex trader has succeeded using a single indicator strategy.
When you use a single indicator in isolation, it means that your entire strategy will be based on that, nothing else.
To confirm reversals, trends, volatility and momentum more accurately, you must combine stochastic with other indicators, price movements and chart patterns.
#4: Stochastic Indicator works best with the trend following strategy
Trend following is a popular strategy in Forex trade.
Trend following signals draw their strength from the fact that they consider the market movement.
You can use stochastic to enter the market on pullbacks within a trend.
A pull-back is a short-term movement that goes in contrary to the existing direction of the price trend.
If the market’s movement is above the simple market average, that is, in a bullish environment, you can enter long when a pullback occurs.
When the price is below average and a downtrend occurs, you will have to wait for short entries on pullbacks occurring in the trend.
Overbought vs. Oversold
Most traders make a big mistake when interpreting the concepts of overbought and oversold.
It has made many traders make losses !
The fact is, there is nothing like overbought or oversold in the stochastic oscillator.
The stochastic oscillator doesn’t show the overbought and oversold prices.
It only shows the momentum!
Some traders argue that a stochastic of above 80 means that the price is overbought and a stochastic of below 20 means that the price is oversold.
From this, we can conclude that such traders mean that an oversold market has high chances of going down, and vice-versa.
That is a wrong belief and very dangerous!
From our previous two examples, when the stochastic value is high, say above 80, it’s an indication that the trend is strong, not that it is overbought and likely to reverse.
A high stochastic value means that the price can close near the top and keeps on pushing higher.
A trend in which stochastic remains above 80 for long is a signal that the momentum is high, not that you should prepare yourself to short the market.
Consider the chart given below…
The above chart shows the behavior of Stochastic within a long uptrend and a downtrend.
The stochastic entered both the overbought (above 80) and the oversold (below 20) positions and stayed there for some time, and the trend kept on going.
This confirms what we have stated above, that the belief that the stochastic shows overbought/oversold is wrong.
If you trade based on the above belief, you will run into problems.
A high stochastic value is an indication that the trend has a long momentum, NOT that it is overbought!
The Stochastic signals
Now, let’s discuss the common signals and how traders benefit using the stochastic indicator…
#1: Breakout trading
When you see the stochastic accelerate in one direction with the two stochastic bands widening, it could be signaling the start of a new trend. If you see a breakout out of sideways range, the better.
In the above example, the two red lines show that the stochastic accelerates in one direction.
The price is moving upwards.
However, this is followed by a new trend, where the price begins to move downwards.
#2: Trend following
If the stochastic remains crossed in one direction, it means that the trend is still valid.
#3: Strong trends
Whenever the stochastic is within the overbought (above 80) or oversold (below 20), don’t fight the trend but instead stick with it and hold on to your trade.
In the above chart, the red, dashed lines show the stochastic in an overbought position.
From the price movement, these two indicate the continuation of an uptrend.
A trader who holds onto his trade at that point will make profit !
#4: Trend reversals
If the stochastic changes direction and leaves the overbought or oversold area, it could be signaling a reversal.
This is demonstrated below…
In the above figure, when stochastic leaves the overbought position, the trend reverses downwards.
When stochastic leaves the oversold position, the trend reverses upwards.
From this, you can conclude that when stochastic leaves an overbought or oversold position, it could be signaling an impending trend reversal !
Common Mistakes when using Stochastic Indicator
There are 2 mistakes that traders commit when using the stochastic indicator.
These mistakes end up costing them hundreds or even thousands of dollars in the long run.
Let’s discuss these two deadly mistakes…
#1: Going long because the market is oversold
Always remember that the stochastic indicator measures the momentum in the markets.
This means that when it’s in an overbought position, that is, above 80, it indicates a strong bullish momentum in the market.
So, what does it mean?
It means that going short just because the stochastic is overbought is a “blind” move!
The above chart shows that if you had gone short because the market is overbought, you could have had a painful experience.
The reason is that the market can remain in an overbought or oversold position for long than you can expected.
#2: Thinking that the market will reverse because of a divergence
A divergence occurs when the price movement is not in sync with the indicator that you’re using .
For example, the price may make a higher high but the indicator may show a lower high.
This shows that the two signals will be diverging from each other.
Most trading text books will tell you that whenever you spot a divergence, a reversal is about to occur.
This cannot be further from the truth.
It’s possible for a divergence to occur, only for the market to fail to reverse !
How to Predict the Market Turning Points
The major reason as to why traders fail when using the stochastic indicator is failure to use it in the market context!
What do I mean?
It’s simple, just trade with the trend, not against it!
You can avoid mistakes if you don’t trade against the trend.
Now, let’s see how you can use the stochastic indicator to predict the turning points of a market.
Always remember these two points…
#1: If the price is above 200-period moving average (MA) and the stochastic is oversold, look for long setups.
#2: If the price is below 200-period moving average (MA) and the market is overbought, look for short setups.
Consider the following example…
The chart clearly shows that the price is below 200-period MA. This means that you should look for short setups.
The stochastic indicator shows some overbought positions. These are a signal that the pullback may end anytime soon.
However, don’t go short “blindly” simply because the stochastic is overbought.
It can help you know the position at which the pullback will end.
With such knowledge, you can time your entry into the trade well and trade with the trend !
How to Time your Entries
In candlestick patterns, the choice of the entry point is subjective.
However, the stochastic oscillator doesn’t give you that problem.
The reason is that there is no discretion for the entry.
You just say YES, and enter, or NO, and stay out!
If you’re the trader who struggles when choosing where to pull the trigger, this is the best technique for you.
Here is a simple trick…
- In case of a long bias, go long when the stochastic line moves above 20.
- In case of a short bias, go short when the stochastic line moves below 20.
This is demonstrated in the following example…
So, what does the chart mean?
We use the indicator chart to measure momentum.
So, when the stochastic crosses above 20, it means that a bullish momentum is about to step in. The vice versa is also true!
Again, you may think that this is a trading strategy, but it’s not.
It’s simply an entry trigger to help you get into a trade!
Combining the Stochastic Oscillator with other Technical Indicators
It’s possible for you to combine the stochastic oscillator with other technical indicators.
To get meaningful signals and improve the quality of your trades, combine the stochastic indicator with these 3 tools…
Moving averages act as filters for your signals.
Always make sure that you trade in the direction of your moving averages.
Also, always look for longs, provided the price is above the moving average. The vice-versa is also true.
The above chart shows the red stochastic crossing below the overbought position for the first time.
Shortly after this, the price breaks the moving average!
The black line is the moving average.
When the price breaks such a formation with an accelerating stochastic, it could potentially signal a successful breakout.
You can trade stochastic reversal or stochastic divergence with trendlines.
You’ve to identify an established trend with a valid trendline then wait for the price to break it with the confirmation of your stochastic.
- The stochastic oscillator is an indicator that measures momentum.
- That momentum measures the rate at which the price of a security accelerates towards a certain direction.
- Don’t go short because stochastic has been overbought. It can remain in that overbought position for a long time.
- The occurrence of a divergence does not mean that the price will reverse. Many are the times it fails in a trending market.
- In a downtrend, an overbought level on Stochastic can help you time when a pullback might end. The vice versa is true in an uptrend.
- The Stochastic can act as an entry trigger to go long once it rises above 20 and short once it cross below 80.
- It’s always good when the stochastic indicator is used together with other technical indicators. It helps the trader understand his trades better and increase his chances of success.