01 Jun 2020| AtoZ Markets - Stochastic Oscillator is a default trading indicator that can be found on any trading platform. Its default parameters are (7, 10, 3), which can be changed by the user's choice. Most of the professional trader trades with the default parameters by combining other indicators to find high accuracy trades. Stochastic Oscillator mostly used on a divergence, scalping, intraday trading, assure overbought/oversold and to buy/sell ensure. The stochastic oscillator is one of the best tools for a trader to use.
What Is the Stochastic Oscillator?
In 1950s, Dr. Gorge Lane invented the Stochastic Oscillator indicator. It was invented to find buying and selling pressure of the market. It can also identify the cycle rotation that spares power within bulls and bears. Many traders take benefit of this reliable indicator. A stochastic oscillator is a momentum indicator. It ranges between 100 and o by default. It shows the location of the close relative to the high-low range on a set number of parameters. Stochastic Oscillator contains two lines - %k is the slow Oscillator and %D is the moving average. Slowing is generally applied to the indicator's default setting as a period of 3. Below is the default setting of the Stochastic Oscillator looks on the Meta Trader trading platform:
When Stochastic Oscillator applied on the default setting to the chart, it looks like this:
Stochastic Oscillator Formula
Stochastic Oscillator is combined components of lines "Slow Stochastic" and "Fast Stochastic".Which is divided into three variants that monitor behind time and range of data level.
- Fast %K represents the closing price by comparing with previous periods.
- %K slows down fast %k with a simple moving average
- %D adds a second average
- C is the current closing price
- The lowest low is the lowest for the time frame
- Highest High is the highest high for the time frame
Uses of Stochastic Oscillator
Below are the basic uses of the Stochastic Oscillator indicator:
Overbought and Oversold levels
When the Stochastic reading is above 80 levels indicating the market is overbought. Below 20 indicates the market is oversold. Usually, the market gives sell signals when Stochastic lines are above 80 and return to below 80. In contrast, the market gives a buy signal when Stochastic lines are below 20 and return to above 20. Moreover, when the security price is near the top or bottom level, the Stochastic signals of Overbought and oversold by residing inside the range of the specific time frame.
Divergence happens when the asset price makes a new high or low without showing on the Stochastic Oscillator. As an example, the price goes to a new high. Still, the Stochastic doesn't move to a high reading accordingly. It is called bearish divergence. Bearish Divergence can signal a forthcoming market shift from a bullish trend to a bearish trend. The momentum of the bearish trend starting to collapse is showing by the Stochastic Oscillator's failure to indicate new high reading together with the price. Likewise, the Stochastic Oscillator doesn't move to the low reading when the price is making a new low, that's called bullish divergence. Bullish Divergence suggests a probable upcoming market switch to the upside.
It's necessary to say, sometimes before the price is changing its direction oscillator can indicate a divergence signal. For example, a Stochastic Oscillator is giving a divergence signal. But the price may go upward for a few amounts of the trading sessions and after that turn downward. That's why Dr. Gorge Lane advised, to wait for some confirmation of the market shift before entering any trade. So, you shouldn't trade relying on divergence only.
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Divergences allow us to anticipate possible countertrend movements as an indicator. It shows the speed and magnitude of a movement through numbers, and we usually refer to it as an oscillator. For the stochastic oscillator, the use of divergences has great support in our trading.
In conclusion, the stochastic oscillator is very good for identifying possible divergences concerning the price.
Specifically, the fast stochastic oscillator. The stochastic oscillator is a technical market momentum indicator that shows us where the closing price is for the range. Between the high and the low during a given set of periods.
At which point the fast Stochastic line and the slow Stochastic line intersect that impose to crossover. %K line is the fast Stochastic line, and the slow Stochastic line is the %D line. The bullish crossover happens when the %K line intersects the %D line and goes upon it. Besides, the intersection of the %K line to %D line from upside to downside Stochastic line indicates a bearish sell signal.
Stochastic Oscillator Limitations
The major disadvantage of the Stochastic Oscillator is the tendency of giving wrong signals. Particularly during stubborn and highly volatile trading situations. So it's important to wait, for a confirmation of the signal from the Stochastic Oscillator along with other technical indicators. The Stochastic Oscillator was invented mainly to measure power and weakness, not the trend. By using utmost readings from the Stochastic Oscillator indicating an overbought or oversold situation in the market, some traders target to reduce the oscillator's tendency of giving false signals.
Traders can mix different oscillators such as the MACD or the RSI with the stochastic oscillator. This would help to improve the signals in our trading strategy.
Best Stochastic Oscillator Settings
You have to choose first, how much noise of data you're ready to accept for your trading method. The more knowledge you have with the indicator, it will enhance your sustaining of probable signals. Some professional traders choose the low setting for short-term trading or scalping. Some traders choose high settings for long-term trading. Because a highly smoothed outcome only responds to the key changes in the price action.
NZDUSD shows different Stochastic Oscillator parameters rely on variants. After reaching the overbought and the oversold level, the fast line intersects the slow line then Cycle turns over. Moreover, the 5, 3, 3 parameters turn over buy and sell cycles repeatedly without reaching the overbought and oversold level. Besides, the 21, 7, 7 parameters work based on a longer period. But keep easing at a comparatively low level, and gives fewer buy and sell signals. Furthermore, the 21, 14, 14 parameters work on a giant dataset, rarely give signals, and are mostly near the key level.
Stochastic Oscillator and Pattern Analysis
When the price pattern shows regular barriers, Stochastic don't have to reach the ultimate level to give reliable signals. While the deepest turns are expected at the overbought and oversold levels, and crosses within the middle of the panel may rely on, then renowned support or resistance levels line up.
NZDUSD climb above the 50-day EMA after volatility decreased and created new support (1). It is forcing the Stochastic line to turn higher before reaching the oversold level. Also, it broke above the falling trend line and pulled back (2) triggering a bullish crossover at the middle point of the panel. Besides, the bullish rally reversed back to find support at the 50-day EMA (3), while triggering a third bullish move above the oversold level.
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Many traders fail to understand the power of Stochastic. Different traders have a different mindset about using Stochastic. Some of them use the default setting only. And some of them use it by combining it with the other indicators like - RSI, MACD, MA, EMA, etc. You have to find what Stochastic Oscillator settings suit your psychology and trading style.
The stochastic determines when a bullish or bearish movement may occur in the market. The stochastic oscillator using the crossing of two indicator lines.
The Stochastic is a very efficient oscillator type indicator to use.
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