What is the Stochastic oscillator and how to use it?

Many people don’t trust classical tools for technical analysis installed on trading platforms. It isn’t a good decision. The most important reason why they were added there is the high quality of their work. The only condition is a correct usage of this tool. Today, we have a plan to describe a widely used tool of technical analysis – the Stochastic oscillator (we will use SO abbreviation below). Many strategies use it. Let’s describe them in detail.

Description of this tool

About 30 years ago, a prevailing number of analysts of the financial markets believed that a certain price on exchanges depends on a huge number of reasons that are hard to analyze. It is true, naturally. However, analyzing the trading history has shown us an opportunity to understand the action of the quotations in the future.

After that, many analysts created special methods that were called “indicators”. What do they mean?

Those are special tools that allow us to predict trend dynamics and understand a certain asset better at this moment.

We can name many great indicators for technical analysis. Their number is over 1,000. Despite the information that some are familiar only to a very small number of professionals, we have a lot of tools that can be used by beginners and professionals.

SO was created by George Lane in the 50s of the 20th century. A lot of people confuse it with RSI by the principle of how it works and what signals it gives. The difference between the Stochastic oscillator and RSI isn’t big. They have an oscillator that is created by Larry Williams in the core.

Stochastic gives us great signals. That’s why this technical tool is so popular. It is on all the platforms for making orders on financial markets and separate services of technical analysis. Naturally, it is implemented in MetaTrader 4, which isn’t an exception. Yet, many specialists in trading (for newbies this fact is very valuable) don’t use it correctly. 

History of finding Stochastic oscillator formula

This tool for different financial markets was created by George Lane. At that time, all the calculations had to be made by traders, and many specialists were improving formulas to make this process more effective.

They gave these tools the names %A, %B, %C, etc. However, only 3 showed a real success: %K, %D, %R.

It is an interesting legend about the history of the indicator. One of the people who helped Lane was an old person who moved from Czechoslovakia and made a lot of attempts to describe to him a formula that was used in his country when he needed to understand how much limestone needed to be added in smelting to iron ore to get steel. They took it, adapted it to their needs, and started to try it. It was the start of the tool we describe today.

Using this picture, you can compare these oscillators. At the top is a graph of the dynamics of quotes. Quite lower, the RSI graph is placed. At the bottom of this picture, SO is with two graphs. You can see the difference between these indicators in the screenshot. It is obvious now, isn’t it?

What is the Stochastic oscillator and how to use it?

Why is Stochastic so important?

It detects how the quotation is changed and can predict future trends when there is a flat. It tries to show the speed at which the price is changing at every moment.

The easiest oscillator takes a cost of some financial instrument or asset and subtracts from it the quote that was several years before this moment. Suppose that the process of making an operation with the EURUSD currency pair on the Forex market ended. At this moment, the cost was 1,2050 and 10 days ago it was 1.20000. The difference is 0,0050.

Let’s give an example. If we use the 14-day variant of Stochastic, we calculate positions of the closing prices between highs and lows for the last 14 days. Stochastic shows a closing price and a range of maximum and minimum ratios from 0 to 100.

If our value is 70 or more, it means that the closing quotation is placed close to the high boundary. If the value is 30 or below, the closing quotation is close to the low border of our range.

If you see 50%, it means that the closing price is precisely in the middle between prices that were maximum and minimum. It is a rule that needs to be used always when you use this oscillator. But simultaneously, you have to use filters for all the signals. 

If it shows us 75%, the price of closing the candlestick is placed at a level of 75%. It would be at 75% of the daily range, or closer to high. If the market is closing every day at the high quotes, we will see 100% on the graph at the bottom of the platform. The idea of trading strategy is the following: if the price tends to close at the top of the range of daily price movement, it is an ascending trend. If it is at the lower part of the graph, it is a descending tendency. 

The Stochastic oscillator will tell us about the change in the direction of the market movement before the price will really be changed. It is associated with a lot of opportunities. You can make an order on the market at the best price and understand when you need to exit it. 

The serious criticism is caused because many oscillators give false signals. For example, they can give a signal to trade, but the asset is in the flat of an intensive movement. 

Oscillators are great tools that allow you to make orders on markets that don’t have any trends at this moment. However, if there is a clear for understanding tendency on the market, oscillators don’t give us such great results. The simpler the oscillator is, the more sensitive to the change in the price of the market it is. For instance, a simple indicator that has a 10-days tempo of change is more sensitive to the dynamics of the current quotation than the Stochastic that has a 30-day span at the base of it.

Many analysts are seriously suffering from simple technical indicators. That’s why they made many attempts to make them better. Stochastic shows the location of every quotation in the closing market in the previous range between maximums and minimums. SO is much more difficult compared to Williams %R. It has a complicated sequence of actions that you need to perform for deleting false signals. Stochastic consists of 2 lines. The first one of them is fast, which is called %K, and the slow one is %D.

The difference between RSI and Stochastic

SO and RSI are very similar tools. Even their settings are the same. You may set the period you think is suitable for a certain situation. Stochastic has values that can vary from 0 to 100. However, its key zones are quite wider than RSI has, and key levels are 20 and 80, not 30 and 70 as RSI has. 

Why is the corridor different? The most important reason for it is the very high volatility of Stochastic compared to other oscillators. The second reason for this difference between them is the fact that SO draws 2 lines instead of one. The %D is a MA of the line %K that has a shorter period. This combination can protect you from wrong signals. This is one of the most valuable advantages of SO.

The fact is that the exact trading signals on the Stochastic Oscillator are a crossing of two lines, and when their values are from 80 to 100 or from 0 to 20. RSI doesn’t have any opportunities to give these signals.

What are the main properties of Stochastic?

  1. The %K line is the main period. It is a period of the oscillator. 
  2. The period of a signal line %D of the oscillator is moving average of %K line.
  3. Deceleration is an additional smoothing of the %K and %D lines.
  4. Prices used for calculating the oscillator are highs and lows of candlesticks or closing prices.
  5. A method that is used for calculating moving averages is the same as for the standard moving averages.

How can we understand what line is a certain one? It is easy. One of the lines is indicated by a solid and the other by a dotted line.

How to use a Stochastic oscillator?

In general, the principle of interpretation of the Stochastic lines is similar to the principle of RSI. They are the situations when the market is overbought or oversold. However, the values are 20 and 80.

The second signal is a divergence. When the market is ascending but the oscillator is descending or vice versa, it is a powerful signal to buy or sell the currency, shares, or other financial assets.

The midline is also important. If the indicator crosses it, it is a signal of entering the market with a certain order. 

The Stochastic oscillator strategy depends on risks that you are ready to take. However, it is based on the signals above.

Wrapping up

We described the main features of the Stochastic oscillator, explained how to calculate and interpret it. The indicator is used to predict the tendency on the flat market. It is very similar to RSI but there are some differences between these indicators.

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author

Carolyn Huntington is an economist, professional trader, and analyst. She made her first big deal in her student years with a profitable investment in Facebook stock. Now the total experience of her trade is 18 years. Over the years of trading, Carolyn has developed its own strategy that allows even those who have never traded on the stock exchange before to earn money. She also creates market forecasts and advises major shareholders, compiles investment portfolios, and teaches how to work with automated advisors.

telephone: 503-547-5192