What is the stochastic oscillator?
The stochastic oscillator is a momentum indicator credited to George Lane, who created it in the late 50s. In his words, he believed “momentum changes direction before price,” hence the inspiration for the tool.
Before going further, it’s good to explore what momentum is in forex. Any stochastic trading strategy is based on this concept, meaning it’s helpful to understand it.
The definition of momentum in the trading context is similar to what you might have studied in physics. It describes the quantity of force or rate of acceleration in price movements. The market can move in any direction, but momentum dictates how many pips it travels.
Strong momentum leads to sustained price movements, while weaker momentum results in slower motion.
A central component of the stochastic oscillator is the moving average (MA), which measures momentum over X number of days. This indicator consists of two MAs named the %K line and %D line (or trigger/signal line).
The %K line is the ‘fast’ MA (default setting of 3-period), while the %D line is the ‘slow’ MA (default setting of 5-period). Both of these moving averages are calculated over the past 14 periods. Of course, you can alter stochastic settings for forex to suit your preferences.
This information is plotted on a line graph that oscillates or moves between 0 and 100. 20 and 80 are the stochastic oscillator settings of extreme values.
20 represents ‘oversold’, suggesting powerful downward movements. On the other hand, 80 reflects ‘overbought,’ meaning that the price is moving forcefully in an uptrend.
Below is an image of the forex stochastic oscillator on a candlestick chart for visual comprehension. The %K line is in blue, while the %D line is in orange.
Stochastic trading strategies help identify divergence, overbought/oversold conditions and crossovers. Let’s explore these in more detail next.
Common stochastic strategies
Regardless of the stochastic indicator strategy, this tool has three primary uses:
Observing overbought/oversold conditions
In currencies, a pair is overbought when it has forcefully moved upward, while oversold means that the price has moved aggressively downwards. Traders interpret these scenarios in two ways when using a stochastic forex strategy.
The first suggestion is that the price will retrace since it has gone too far. Although this does happen often, overbought/oversold is an excellent signal for trend continuation. This quality can serve you well when you’re in an existing position with the stochastic oscillator.
The idea is to keep holding the trade in anticipation that the price will continue moving rather than correcting itself.
On the GBP/CHF daily chart below, notice how long the market stayed overbought on the indicator. When the price first entered the 80 zone, some traders may have exited. Yet, with some patience, the pair continued moving tens of pips.
Here, you could have trailed your stop as the price moved in your favour, finally exiting when the indicator closed below 80.
Divergence is a classic feature of the oscillator indicator family, found in several momentum tools like the CCI, MACD and RSI. It goes back to the concept of momentum changing before the price.
Divergence in the stochastic oscillator shows a mismatch between the highs/lows of the market and the indicator.
Although we have several types of divergence, the idea is the same. With regular bullish divergence, the price shows two consecutive highs, while stochastics reflects a higher high and lower high.
The opposite is true for bearish divergence: two successive lower lows on price, and a lower low + higher low on the indicator.
Divergence is a tried-and-tested method for detecting reversals, making it a component of the average stochastic oscillator strategy. However, it is something to combine with other elements rather than using it on its own.
Here, we see a nice rising wedge, a classic reversal pattern. This was in addition to the bearish divergence, which would have offered more confirmation of the eventual reversal.
Any forex stochastic strategy relies on information from moving averages. So, using crossovers is a given. The main purpose of this feature is to spot trend changes. A crossover happens when one stochastic oscillator line intersects with another.
When the 3-period %K line crosses below the 5-period %D line, it is regarded as a selling trigger. Conversely, it is a buy signal when the 5-period %D line crosses above the 3-period % line.
Generally, traders use crossovers as entry or exit triggers. So it should only form a small part of your strategy combined with other factors as previously discussed. You can use crossovers with the stochastic oscillator for trends and reversals.
The 4HR chart below of EUR/USD shows an uptrend, and the various entry crossover triggers you could have identified.
Pros and cons of using stochastic oscillator
So, what are the good and bad things about using the stochastic oscillator?
- Simple to understand: This indicator is universally accepted due to its ease of use. All types of traders, ranging from scalpers, day traders, and swing traders, position traders to automated traders can benefit from it.
- Universal availability: The stochastic oscillator is not a custom indicator. So, you should find it on all standard charting packages.
- Identifies trend changes and reversals: Although most chartists consider stochastics a reversal tool, it can be useful for spotting trend changes too.
- Inherent lagging: Like all technical tools, the stochastic oscillator lags. This means that the indicator produces a trigger after the fact. Therefore, you can expect many false signals. This is why using confluence or combining the tool with other elements is crucial for making the best decisions.
- Choppiness: Here, we mean that the indicator is more sensitive to the slightest price changes. This is because the default periods are shorter (3 and 5). Such a quality works best on lower time frames where scalpers and day traders thrive.
Yet, it is a problem when you are looking at higher charts. You can derive ‘smoother’ results by using higher periods. On the plus side, the lower periods may offer an edge during range-bound conditions (but not in trending ones).
Forex stochastics are generally the least used momentum indicators since the RSI indicator is more preferred. It produces smoother results and has less components to it. However, you can combine the two with the Stochastic RSI custom indicator.
Otherwise, the stochastic oscillator is also brilliant on its own but, again, should be used in conjunction with something else. This not only applies to forex but other markets like crypto, options and metals.