Learn how to trade with Bollinger Bands® | OANDA

• What stochastic oscillator is and it’s history
• Find different signals for trade entry using stochastic oscillator
• Use Stochastic oscillator and 200 exponential moving average (EMA) together

The stochastic oscillator (also known as ‘Lane’s stochastics’) was developed in the late 1950s by George Lane. Lane was a trader, author, speaker and educator interested mostly in technical analysis. Over the years, through his trader education and books he popularized the stochastic oscillator to the point it is one of the core indicators used today by technical traders.

As George Lane said himself:

‘Stochastics measures the momentum of price. If you visualize a rocket going up in the air – before it can turn down, it must slow down. Momentum always changes direction before price.’

The stochastic oscillator is one of the most popular tools used by forex and stock market traders. Once you understand how to use it properly, it can be useful in helping you anticipate price reversals.

When you add the stochastic indicator to your chart, you’ll see there are two lines moving up and down a scale marked 0-100, with one line being faster than the other. These two lines are known as:

1. %K, also known as ‘stochastic fast’

This line shows where the price is in relation to the recent range of price movement and is given a value as a percentage. If the value for %K is 5, we would be looking at a period of five days, for example.

2. %D, known as the ‘signal line’

1. Typically, this line uses the last three valuations of %K to create a moving average of the %K stochastic. %D is a moving average of %K and is referred to as ‘stochastic slow’ since it reacts more slowly to market price changes than %K.

Traders use two types of stochastic: the slow stochastic and the fast stochastic. The fast version reacts quickly to changes in price and will generate many signals - unfortunately, many of those will be false, especially in a fast moving market. The slow stochastic helps remove much of the noise by replacing the %K line with the %D line and the %D line with a three-day moving average of %D, so the signals are more reliable.

The default settings for the stochastic are 5.3.3. Other common settings are 8.3.3 and 14.3.3. Generally speaking, the lower the values the more sensitive the indicator and therefore the more signals it produces.

If you are a swing trader and want to eliminate a lot of the market noise, you could increase the settings on the stochastic. As with the MACD, there are no perfect settings for the stochastic, so the best approach is to backtest the settings for the instrument and timeframes you prefer to trade.

Similar to the RSI and MACD, the oscillations descending towards zero indicate price is moving into bearish territory, whereas the oscillations moving towards 100 indicate price is moving through bullish territory.

• When the stochastic lines are below 20, the market is oversold.

When the stochastic lines are over 80 the market is overbought.

The most popular method for generating entry signals is to consider the stochastic as an oversold/overbought indicator. The majority of trading tutorials teach you that a buy signal occurs when the stochastic moves below the 20 level into an oversold area and crosses back above that threshold, and a sell signal occurs when the oscillator moves above the 80 level and crosses below that threshold.

The problem is, this strategy overlooks the fact that the oscillator is not predicting price but rather momentum in relation to price. As you can see from the over chart for GBP/CHF the stochastic can remain above 80 or below 20 for long periods of time during a strong trending phase. It’s not always the case that if the stochastic hits the 80 or 20 area, price is about to reverse. In fact, momentum is usually strong at these levels and therefore price is very likely to carry on moving in the same direction for some time to come.

What this means is that, during a trending phase, it is good practice to wait for the stochastic line to make its crossover and drop below the overbought area before taking a short trade. Remember, the stochastic can remain in an overbought or oversold area for long periods of time while price continues to go up or down, respectively, so it’s important to consider other factors such as price in relation to moving averages and support and major resistance zones.

In looking to the stochastic to provide you with a buy/sell signal, you are looking for a crossing or crossover of the two lines, the K% line and the D% line.

• When the %K stochastic cuts above the %D Stochastic, you have a potential buy signal.
• When the %K Stochastic crosses over the %D Stochastic you have a potential buy signal.

Some traders pay close attention to the 50-level crossover that occurs when the %K Stochastic crosses the 50 line. This could be seen as a move towards a stronger position and interpreted as a buy signal. When the %K line crosses under the 50 level, the price is said to be weakening and could be a sign to sell the asset.

With this being said, these crossover signals are a lot less reliable when the market is in a strong trend (as you can see in the chart above) and more reliable during a period of consolidation (when price is moving sideways). You can still use the stochastic during a strong trending phase, but you would only take signals in the direction of the trend.

A divergence occurs when the price of, say a forex pair, moves in the opposite direction to the stochastic indicator, showing us that the climb or descent of price action is losing momentum. This could be a sign that a reversal is about to occur. With risk management in mind, if you are looking to trade in a trending market it is best to take only the divergence signals that point in the direction of the main trend, (which is usually the trend you see on the daily chart).

EMA stands for exponential moving average. EMA is a moving average that places greater weight on the most recent data points and reacts more significantly to recent price changes than a simple moving average (SMA). If price is riding above the 200-EMA on the daily chart, it is said to be in an upward trend. Below the 200 EMA it is in a downward trend.

You could filter out noise and reduce false signals using the 4-hour and daily time frames:

• When prices are above the 200 EMA, search for divergences on the lower end of the stochastic.
• When price is below the 200 EMA, look for divergences on the upper half of the stochastic.

You can also use this indicator to spot hidden divergences. These divergences may signal momentum coming into the main trend and a possible continuation in the direction of that trend.

During an uptrend:
Look for price action that is showing higher lows with lower lows on the stochastic.

During a downtrend:
Look for lower highs in price and higher highs on the stochastic.

In the chart below, price is in a downtrend. You’ll notice that, although price is making lower highs, the stochastic is showing some higher highs at the same time. This is what we call a hidden divergence. Two further hidden divergences occur shortly afterwards. This example serves again to remind you that the stochastic is showing you the power of momentum, not the direction of price.

This is why they say, ‘The trend is your friend’.

Just remember, when using the stochastic, it’s always a good idea to seek confirmation by using other indicators, such as the MACD and RSI, and areas of support and resistance before you open or close a trade.

• The stochastic oscillator measures the momentum of price over a given time period and serves as a signal for potential upcoming reversals
• When the stochastic lines are below 20, the market is oversold and when the stochastic lines are over 80 the market is overbought
• Crossover signals are a lot less reliable when the market is in a strong trend and more reliable during a period of consolidation
• Many traders use the stochastic mainly, or purely, to identify divergence between price and momentum
• In a trending market pay attention only to the divergence signals that point in the direction of the main trend
• As with any indicator, it is a good idea to try it out on a demo account first, varying the stochastic settings and comparing your results with higher and lower timeframes.

Seeking information on how to double-check signals with various indicators? Check out the Indicators & Oscillator section available in our learning section. You may also want to explore our other educational material such as our free webinars, workshops and how-to videos. Once you’ve opened an account, live or demo, you can put your knowledge into practice.

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