Forex trading on short time frames involves a considerable degree of technical analysis. Luckily, traders have a multitude of indicators at their disposal to help navigate price charts and make decisions based on observable patterns. The stochastic oscillator is one of the most widely used technical indicators by Forex traders. Forex Stochastic Oscillator indicator shows whether a security is overbought or oversold on the market. When prices reach overbought conditions, it is a signal for going short and when prices reach oversold territory, traders get signals to buy.
Stochastic oscillator indicator overview
The stochastic oscillator is a useful momentum indicator that compares the closing prices of a security to a range of prices over a set period of time. The purpose of stochastic oscillators is to provide traders with buy and sell signals by measuring price momentum on a scale of 0 to 100. 20 and 80 levels are standard, however, some traders change the levels to 10 and 90 to get more precise signals. The obvious downside is that they get less trading signals as a result.
The characteristics and uses of stochastic oscillators can be summarized as follows:
- The stochastic oscillator is a leading momentum indicator that shows areas where the price may be overextended. It also has the features of a lagging indicator in the sense that it uses past price points to send out buy/sell signals
- The indicator measures price momentum by assigning a value of 0 to 100
- The stochastic oscillator uses a default time frame of 14 days
- FX Stochastic Oscillator indicator is placed below price chart
- The indicator is made for trading ranging market conditions
Technical details of the stochastic oscillator
The stochastic oscillator is an indicator that follows price momentum and shows bullish and bearish divergences, which serve as buy and sell signals for traders. Understanding the math behind the indicator and its applications is important for traders, especially for traders who deploy swing trading strategies. Due to its volatile nature, the oscillator is typically used alongside moving averages and the relative strength index (RSI).
Stochastic Oscillator indicator formula
The stochastic oscillator uses a single formula and is calculated as follows:
%K = ((C – L14) / (H14 – L14)) X 100
%K = current value of the stochastic indicator
C = Recent closing price
L14 = the lowest price over the last 14 trading sessions
H14 = the highest price over the last 14 trading sessions
The %K figure is often referred to as the fast stochastic oscillator. To calculate the slow stochastic oscillator, or %D, calculate the 3-period moving average of %K.
Fast, Slow and Full
Three types of stochastic oscillators can be identified based on the timeframes used in their calculations. The fast oscillator can be highly sensitive toward alternating price momentum, which is why the slow oscillator was introduced to smooth the %K value.
In the case of a fast stochastic oscillator, %K is calculated using the basic formula discussed above, and the fast %D value is equal to the simple moving average of the %K value.
In the case of a slow stochastic oscillator, the slow %K value is equal to the 3-period smoothed moving average of the fast %K value. The slow %D value, therefore, is equal to the 3-period smoothed slow %K value.
The full stochastic oscillator is a fully customizable version of the indicator, where traders can set the desired time frame for the slow %K and the %D moving average.
Full %K = Fast %K smoothed with the desired period SMA
Full %D = desired period SMA of Full %K
Overbought and Oversold signals
Stochastic Oscillator indicator in Forex makes it simple to identify overbought and oversold signals in ranging markets. The oscillator ranges between 0 and 100 and traditionally, a stochastic value below 20 is considered an oversold signal and a value over 80 is considered to be overbought. As already mentioned, these values are general and can be changed to fit your trading strategy.
Securities can remain overbought or oversold during extended periods of time, which is why it is important for high and low values to be sustained in a consistent manner to indicate strong buy and sell signals. It is useful to identify oversold signals among strong buying trends and vice versa, as these points are where many profitable trade opportunities lie.
Bullish and Bearish divergences
When trading FX Stochastic Oscillator indicator, you can use it in various ways. One of them is using a divergence strategy. Divergences occur when new highs or lows are not confirmed by the stochastic oscillator. Bullish and bearish divergences can be defined as follows:
- A bearish divergence occurs when the price records a higher high, but the stochastic oscillator shows a lower high
- A bullish divergence occurs when the price records a lower low, but the stochastic oscillator shows a higher low
These scenarios could indicate a bearish, or bullish reversal, respectively. While the oscillator values are not concrete and might change frequently, the midpoint value of 50 is nonetheless important to watch. This is the point that is crossed during reversals, and the distance from this point is what defines overbought and oversold signals.
Practical application of the stochastic oscillator
To better understand how it works, let’s take a look at the Stochastic Oscillator indicator example. Let’s consider the example of GBP/USD to see how the oscillator works alongside other indicators, such as the RSI.
The GBP/USD chart shows the stochastic oscillator plotted below the chart on a 1-month time frame. The chart shows heightened buying and selling momentum, however, the stochastic oscillator alone might not show the full picture. The oscillator value frequently reached above 80, which may not be enough for a full-fledged sell signal.
We can look at the same chart with the RSI indicator added. The RSI is largely in line with the stochastic, which can provide more concrete buy and sell signals. The drop in the stochastic oscillator and the RSI toward the tail end of October is one such buy signal, as the pair was oversold. The value of 50 is the key boundary crossed between oversold and overbought signals.
History and other useful details of the stochastic oscillator
The stochastic oscillator was developed by George C. Lane in the late 1950s. George Lane himself is noted for saying that the oscillator does not aim to measure price or volume, but the momentum of said price. The bullish and bearish divergences are used to indicate reversals.
This was one of the core signals identified by Lane, who used the oscillator to identify bullish and bearish set-ups. The stochastic oscillator is a range-bound indicator that can signal overbought and oversold levels.
FAQs on the stochastic oscillator
What does stochastic oscillator indicator show?
The stochastic oscillator measures price momentum by comparing the 14-day (14-day period is standard and can be adjusted according to your preference) price performance of an instrument to indicate whether the instrument is overbought or oversold. Traders can interpret this information as buy and sell signals. Overbought condition means that we can sell the asset and oversold condition signals to buy. The indicator predicts the price will reverse.
Is stochastic oscillator indicator safe?
The stochastic oscillator can be sensitive to rapidly alternating price momentum. This is why the indicator is used alongside the RSI and moving averages to provide a clearer, smoother picture and more reliable overbought and oversold signals. The oscillator might produce false signals in ranging and highly volatile markets.
Is stochastic oscillator a good indicator?
The stochastic oscillator is one of the most frequently used momentum indicators. The changing price momentum can provide valuable insights into retracements and reversals on the market. Stochastic Oscillator indicator FX traders use is simple to understand and trade, which is why it’s highly popular among both novice and experienced traders.