trading strategy

You can use together with moving averages (long-term and short-term definitions of the same indicator), and support and resistance levels. The latter is a bit more complex to code, though, and is mostly used discretionary. The stochastic indicator does work in a stochastic trading strategy. It performs quite well as a mean-reversion tool for stock indices. Minimum periods of %K and smoothing lines are ideal for the 5-minute chart. They help get a sufficient number of signals, most of them are useful.


Learn how to trade forex in a fun and easy-to-understand format. Composer is a registered investment advisor with the US Securities and Exchange Commission . While such registration does not imply a certain level of skill, it does require us to follow federal regulations that protect you, the investor. By law, we must provide investment advice that is in the best interest of our client. However, we recommend backtesting your trading ideas unless you want to trade blind. The past is normally a good indication as long as you avoid curve fitting.

Stochastic Indicator Calculation & Formula

We know from previous articles that the IBS indicator works really well on stocks, and thus it’s no surprise to see stochastic performing well. However, just like the RSI, the results can be improved by including one or more filters. Usually, the period of the stochastic oscillator refers to the period of the %K curve. It defines the range that is used to compare the current price.

The period is set to 14 so that there is a large enough data sample to give a meaningful calculation but short enough so that it’s responsive to changes. You can modify the lookback period on your trading platform to adjust the stochastic oscillator’s responsiveness. It’s a general belief that momentum tends to change direction before price.

How is the stochastic indicator calculated?

These levels can be adjusted to suit analytical needs and security characteristics. Readings above 80 for the 20-day Stochastic Oscillator would indicate that the underlying security was trading near the top of its 20-day high-low range. Readings below 20 occur when a security is trading at the low end of its high-low range. Therelative strength index and stochastic oscillator are both price momentum oscillators that are widely used in technical analysis.

The crossover is another popular strategy used by traders. This occurs when the two lines cross in an overbought or oversold region. A stochastic study is useful when monitoring fast markets.

The oscillator is based on the idea that that closing prices will remain near historical closing prices, while the RSI tracks the speed of the trend. As we have seen, the stochastic oscillator is shown as two lines on the chart, the %K and the %D . When these two lines cross, it is a sign that a change in market direction is approaching. If %K rises above %D, it would be a buying signal – unless the values are above 80. And if %K falls lower than %D, then it’s seen as a selling signal – unless the values are below 20.

slow stochastic oscillator

Also, the stochastic didn’t reach the oversold area but soon returned to the overbought conditions. Chart 3 shows Yahoo! with the Full Stochastic Oscillator . A longer look-back period and longer moving averages for smoothing produce a less sensitive oscillator with fewer signals. Yahoo was trading between 14 and 18 from July 2009 until April 2010. Such trading ranges are well suited for the Stochastic Oscillator.

In low margin, calendar futures spreads, one might use Wilders parabolic as a trailing stop after a stochastics entry. A centerpiece of his teaching is the divergence and convergence of trendlines drawn on stochastics, as diverging/converging to trendlines drawn on price cycles. Dr. George Lane developed the Stochastic Oscillator in the late 1950s for use in technical analysis of securities. Lane, a financial analyst, was one of the first researchers to publish research papers on the use of stochastics. He believed the indicator could be profitably used in conjunction with Fibonacci retracement cycles or with Elliot Wave theory. Technical analysis focuses on market action — specifically, volume and price.

Touching or crossing the 20% level will be a signal to close a position. When applying the stochastic oscillator on a chart, divergence occurs rarely, but its signals are highly accurate. A %K line curve crosses the %D one downwards at a price range, slightly above 80%. Therefore, analyzing the behavior of the stochastic lines, we can open a short position near the close price of the candlestick where the cross happened. When the %K curve crosses the %D line upside-down, strong sell signals are monitored meaning that a bearish trend begins. A short position should be open slightly below the breakout point.

Stochastic Divergence

A Bull Setup occurs when price records a lower high, but Stochastic records a higher high. The setup then results in a dip in price which can be seen as a Bullish entry point before price rises. On the other hand, if the Stochastics cross below the 20 oversold level and the RSI is also below 30 then this might produce a bullish alert.

Because the market can remain overbought/oversold for a long period of time – far longer than your account can withstand it. Now there’s nothing magical about it and you shouldn’t think too much about finding the best stochastic oscillator settings. Although the Stochastic indicator is a very simple tool and only looks at a few key data points on your charts, it can provide meaningful trend information.

  • Stochastics is an indicator and oscillator, presumably invented by George Lane as early as the 1950s.
  • Follow these three simple rules, and you will be surprised by the result.
  • Chart 3 shows Yahoo! with the Full Stochastic Oscillator .
  • And the RSI would consider the underlying asset undersold if the indicator was below 30, while the stochastic oscillator would need to fall to 20.
  • The period is set to 14 so that there is a large enough data sample to give a meaningful calculation but short enough so that it’s responsive to changes.
  • It is a versatile indicator that can be used over a wide variety of timeframes which adds to its popularity.

In other words, the RSI was designed to measure the speed of price movements, while the stochastic oscillator formula works best in consistent trading ranges. A stochastic trading indicator is a technical analysis tool used to identify overbought and oversold conditions in the market. It compares a security’s closing price to its price range over a certain period of time and is typically expressed as a number between 0 and 100. Nevertheless, it’s not recommended to trade using only the stochastic oscillator as a momentum indicator. In the simplest stochastic oscillator strategy, signals are filtered by the trend direction. For instance, if a downtrend prevails, open only short positions.

Take time to learn more about the trading strategy of stochastic with Bollinger Bands. The U.S. dollar often continues moving following the momentum when curves enter overbought or oversold zones. Therefore, you should enter the market when there is a price reversal.

As the fast stochastic provides reliable but very frequent signals, another type of indicator was developed – the slow stochastic. It smoothes price movements and provides fewer signals but makes them more reliable. The %K value is calculated on a scale from 0 to 100, with readings above 80 indicating an overbought asset and readings below 20 indicating an oversold market. These levels serve as potential entry and exit points for traders. Similarly, a bearish divergence occurs when an asset’s price moves to a new high, but the oscillator does not correspondingly move to a further high reading.

That’s why this momentum indicator is often used with other indicators for more accurate signals. In the following sections, we will explain the specifics of the stochastic oscillator signal types, methods of interpretation, and detection. The Stochastic Oscillator is a range bound momentum oscillator. The Stochastic indicator is designed to display the location of the close compared to the high/low range over a user defined number of periods. A bullish divergence occurs when the price records a lower low, but the stochastic oscillator forms a higher low.

Moving average convergence/divergence is a momentum indicator that shows the relationship between two moving averages of a security’s price. On a stochastic oscillator chart, %D represents the 3-period average of %K. This line is used to show the longer-term trend for current prices, and is used to show the current price trend is continuing for a sustained period of time. There are no 100% accurate instruments of technical analysis. It provides plenty of signals, but some of them are false. When the market is temporarily oversold in the uptrend, signals on a bullish reversal usually don’t work.

Stochastics measure the momentum, not the range of the price movement. This inconsistency is what turned off many followers of stochastic oscillators. The argument that the oscillations were often too choppy and the range of the oscillations were not proportionate to the price moves of the underlying stock . A bear trade setup ensues when the stochastic indicator makes a lower low. Yet, the instrument’s price makes a higher low, indicating that selling pressure is mounting as the security’s price may fall even more. As a result, traders often look to place a sell trade after a brief rebound in the price.

It is a versatile indicator that can be used over a wide variety of timeframes which adds to its popularity. When it comes to generating signals, the Stochastic Oscillator can indeed produce quality signals. Keep in mind though, that when using it as a signal generator (especially for divergences and bull/bear setups) it is best when used going with the trend. The technical analyst should be aware of the overall trend of the market. It would not be unwise to use Stochastic along with other means of technical analysis such as trend lines to confirm the market direction.

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For further affirmative signals, traders may also wait for the %D line to rise above 20. A reading of 100 means that the latest closing price is equal to the highest price recorded for the price range over the chosen time period. The %K determines where the price closed in relation to a range (i.e. period) of candlesticks.

The blue circle points to the moment when the bar touches the bottom line. In the same area, the %K crosses %D from the bottom, thus, confirming the primary signal. We can enter the market at the opening of the next candle after the signaling one. Below, we’ll look at stochastic trading features on the S&P 500 futures, gold, and the U.S. dollar. To understand the stochastic swing strategy, we should learn the “Star” pattern.