Stochastic Oscillator: Settings and Strategies

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Published: March 1, 2021 by Andrew

Stochastic Oscillator is an indicator that compares the closing price of an asset with its recent highs and lows, over a given period of time. It provides readings that move (oscillate) between 0 and 100 to provide an indication of the Momentum of the Stock.

Stochastic readings are essentially percentage expressions of the trading interval of a security in a given period of time.

The default setting for the Stochastic Oscillator is 14 time periods: every hour, every day, etc. A reading at 0 represents the lowest point of the trading range. A reading at 100 indicates the highest point during the designated time period.

To fully understand the Stochastic Oscillator we will analyze:

  • The idea behind the Stochastic Oscillator
  • The formula and the setting
  • Trading strategies with the Stochastic

In this guide we will explain how to take advantage of this indicator and how to use it in trading. If you want to immediately access a trading platform to do some tests, perhaps in Demo, here is a list of the best trading platforms on the market, online brokers like eToro, reliable and without commissions:

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    Stochastic Oscillator: what is it?

    The graph of a Stochastic oscillator allows you to identify the momentum in the price of a financial asset, its acceleration.

    At the heart of this indicator is the Stochastic Oscillator formula. What this does is compare a stock’s closing price with recent highs and lows. Then it converts it into a figure between 0 and 100 which is the actual value of the oscillator.

    If you ask two traders what the Stochastic oscillator shows, you will probably get very different answers.

    For some, in fact, this trading indicator shows the momentum, the upward or downward momentum of a stock, for others it indicates overbought and oversold.

    Both explanations are correct in theory. The key difference is how you decide to use this indicator in your trading strategy.

    Obviously there are many factors to consider when using the Stochastic oscillator, one of these is the intervention time period, which is adjustable and is part of the indicator settings.

    Depending on whether the strategy adopted is short or long term, the Stochastic setting must necessarily be changed, but we will see this later in our guide.

    Where to use the Stochastic Oscillator

    To use the Stochastic Oscillator it is necessary to have a trading platform, a software that makes this indicator available on the price charts.

    The CFD Brokers that we have listed at the beginning of the guide are the ideal choice to test this indicator and practice.

    In fact, these intermediaries, in addition to offering the possibility of negotiating on numerous markets, also allow you to operate in Demo, without making any deposit and without risking anything.

    At the end of this guide you will find the links to access the Demo accounts offered by these intermediaries for free, but now let’s see what they offer.

    Copy the best traders

    eToro is the most widespread online broker in the world and operates under the supervision of the regulatory bodies which authorized it.

    How to use the Stochastic Oscillator on eToro?

    • Register for free on eToro
    • Log into your Demo or Real account (making a minimum deposit of € 200)
    • Select the CFD of any stock and activate the Stochastic on the chart
    • Set the indicator according to your strategy
    Try the eToro platform for free

    If you want to learn how to make the most of the Stochastic Oscillator, eToro offers you the opportunity to learn from the best traders in the world.

    In fact, with Copy Trading, an automatic trading system patented by eToro, you can choose the traders you prefer, among the best who use eToro, and the software will copy all their operations on your trading account.

    Thanks to this tool you will get a double advantage:

    • You will have the same results obtained by the traders you are copying
    • You will learn how these experts use the Stochastic Oscillator and other trading indicators

    Before making real investments, you can practice with the Stochastic Oscillator and Copy Trading in Demo, without running any risk.

    Click here to sign up for free on eToro

    Learn with a Trading Course

    To learn how to use the Stochastic Oscillator you need a lot of practice but above all the knowledge of the basics of technical analysis.

    ForexTB is a very high level broker that offers a perfect Trading Course to learn how to exploit this indicator.

    The ForexTB Course is in ebook format and is the most downloaded in its category.

    It is a very well made pdf, complete and with many practical examples, to learn how to use trading indicators, including the Stochastic.

    This ebook is free and to download it just use the link below:

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    Stochastic Oscillator: a hint of history

    The history of the Stochastic Oscillator begins in the late 1950s thanks to Dr. George Lane who used it for the technical analysis of stock market securities.

    Lane, as a financial analyst, was one of the first researchers to publish documents showing the use of the Stochastic. He believed that this oscillator could be exploited in combination with Fibonacci Retracements and Elliott Waves but he soon realized that the Stochastic was mostly indicating price momentum, not so much trend.

    The oscillator compares the position of the closing price of a security with respect to the maximum and minimum in a specified period of time. In addition to measuring the strength of the price movement, the oscillator can also be used to predict market reversal points.

    Stochastic Oscillator: the formula

    la for calculating the stochastic oscillator is this:

    • % K = (Last Closing Price – Lowest Price) / (Highest Price – Lowest Price) x 100
    • % D = 3-day SMA of %K

    Where %K is the fast Stochastic and %D the slow one.

    But you will never have to do this calculation, we just entered it to understand how it works. The trading platform will calculate the value of the Stochastic oscillator and show it to you on the chart.

    How does the Stochastic Oscillator works?

    Let’s now see how the Stochastic oscillator works. At the base is the concept of price momentum that can be “measured”.

    The stochastic value shows whether the stock is in an overbought or oversold phase.

    Usually the concept of oversold occurs when the Stochastic falls below 20, while above 80, it means that the asset is overbought.

    Taking 50 as the average value, in theory, the positive momentum is above the line, while the negative momentum is below it. While this is generally the case, you have to be very careful with false signals, which are very frequent.

    Stochastic Oscillator: trading strategies

    The Stochastic Oscillator is used with particular strategies, which try to limit false signals, let’s see which are the most effective.

    Overbought and Oversold

    As mentioned above, an overbought level is indicated when the stochastic reading is above 80, while readings below 20 indicate oversold conditions.

    • A sell signal is generated when the oscillator reading exceeds the 80 level and then returns to values below 80.
    • A buy signal is indicated when the oscillator moves below 20 and then returns to above 20.

    The overbought and oversold levels indicate that the stock’s price is close to the high or low of its trading range, respectively, for the specified time period.

    stochastic oscillator overbought oversold

    Divergence

    The divergence indicates precisely the contrast between the direction of the trend and the indication provided by the Stochastic oscillator.

    • If the price moves to a new high but the oscillator does not mark a new maximum value, it is a bearish divergence, which could signal an imminent reversal of the bullish trend towards a bearish one. The failure of the oscillator to reach a new high indicates that the momentum of the bullish trend is starting to decline.
    • Similarly, a bullish divergence occurs when the price makes a new low but the oscillator does not show a new lower reading. The bullish divergence indicates a possible market reversal from bearish to bullish.

    The stochastic oscillator can give a divergence signal well in advance of the price.

    For this it is necessary to wait for a reversal confirmation before trading and not rely solely on divergence.

    stochastic oscillator divergence

    Price trend indicator

    The relationship between the fast stochastic oscillator and the simple Moving Average is very important.

    In the chart below there is the first section, dominated by the strong bearish trend with the fast Stochastic oscillator and the bearish moving average. Then there is a rebound and the indicators both remain below 20%, indicating that the momentum is relatively weak. That is until the fast Stochastic breaks the Moving Average line.

    stochastic oscillator price trend indicator

    This momentum change (momentum) is demonstrated by the uptrend that ends when the short-term trend line breaks the Moving Average and falls below the 80% level. At this point there is another trend change and a potential sales signal.

    Crossover

    Crossovers refer to the point where the fast stochastic line and slow stochastic line intersect.

    The fast stochastic line is the 0 %K line and the slow stochastic line is the %D line.

    • When the %K line intersects the %D line and crosses it, this is a bullish indication.
    • When the %K line crosses the %D stochastic line from top to bottom, the signal is bearish.

    crossover stochastic oscillator

    Stochastic Oscillator Settings

    To take advantage of the Stochastic oscillator it is necessary to master its settings.

    The length of the intervention period increases for long-term trading and decreases for short-term or scalping traders.

    There are three variables to consider when setting the Stochastic oscillator:

    • %K = based on the number of time periods used in the calculation
    • Slowdown = Simple Moving Average Factor (SMA) applied to %K
    • %D =%K moving average factor

    The default value of the Stochastic is 14,3,3 and this value should be modified based on 3 factors:

    • The asset to be traded, if for example the stock is very volatile, a slightly “attenuated” Stochastic is needed and it would be better to use higher parameters such as 15.5.5
    • The Timeframe. If we trade on short timeframes, to avoid too many false signals it is preferable to increase the stochastic setting for example to 20.5.5 or 17.9.3. With longer timeframes, on the other hand, the “sensitivity” of the Stochastic can be increased with lower parameters such as 5,3,3 or 6,3,3.
    • The strategy and the use of other indicators can make a difference. The Stochastic, if used in combination with confirmation indicators could be set to give even more signals, because we have another indicator that filters the false ones.

    All these settings produce indications ranging from 0 to 100. Consequently, the longer the period over which the simple moving average is calculated, the more reliable the line will provide, but the fewer signals.

    Conclusions

    The stochastic oscillator is a very popular and widely used indicator of the momentum (or momentum). Traders often use the divergence signals shown by the oscillator to identify possible market reversal points.

    As we have seen, the oscillator tends to generate false signals, therefore, it is better to use it together with other technical indicators, rather than as an independent source of trading signals.

    stochastic oscillator

    To practice with the Stochastic Oscillator without running any risk, it is advisable to start with the Demo accounts offered free of charge by the online brokers we have proposed. When you have practiced with this indicator, you will be able to switch to real accounts, making the minimum deposit required by the Broker.

    Here are the official links to access the Demo accounts of the best online brokers for free:

    What does the Stochastic Oscillator measure?

    This oscillator indicates the momentum of prices in a range between 0 and 100. It also measures when a stock is overbought or oversold, usually above 80 or below 20.

    How is the Stochastic Oscillator used in trading?

    It is used to determine the possible trend reversal of a stock but it generates many false signals and requires the confirmation of other indicators.

    What is the optimal setting of the Stochastic oscillator?

    The default setting 14,3,3 is the most used but in the guide you will find the other settings to use.

    How to use the Stochastic Oscillator?

    By practicing in the Demo accounts of the best online brokers such as eToro, safe and without commissions.

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