Stochastic Oscillator

The Stochastic Oscillator is a technical indicator which shows relative highs and lows based on high-low calculations from previous periods. Stochastic indicators place less emphasis on price, instead focusing on speed and momentum of price movements to determine highs and lows.

The Stochastic indicator is closely related to the force indicator. Once momentum is found, a trader can use the stochastic to ride the waves up or down.

3 Uses for the Stochastic Oscillator:

1. Finding future bullish or bearish trends.
2. Showing overbought or oversold levels in short-term trading patterns.
3. Momentum prediction and reversal spotting.

Stochastic Formula

You can trade the Stochastic indicator—or any indicator, for that matter—without knowing exactly how it works. If you’re disinterested in the mathematics behind this indicator, skip this section. If you’d like to know the nitty gritty of the Stochastic Oscillator’s formula read on.

The formula below describes how the Stochastic Oscillator readings are calculated:

%K = (Current Close – Lowest Low)/(Highest High – Lowest Low) * 100
%D = 3-day SMA of %K

Lowest Low = lowest low for the look-back period
Highest High = highest high for the look-back period
%K is multiplied by 100 to move the decimal point two places

We can work through an example to make sense of the algebraic notation above. The Stochastic measures the closing price relative to the high-low range (high-low range is equal to the high minus the low) over a set period of time. Let’s say that the highest high is 55, the lowest low is 50, and the close is 54.

The high-low range is 5. The close minus the lowest low is 4. Take 4, divide by 5, and arrive at .8. Expressed as a percentage, .8 equals 80%. Multiply by 100 to arrive at a reading of 80 on the Stochastic Indicator.

If you play with the numbers long enough, you’ll realize that the Stochastic Indicator rises above 50 when the closing price is in the upper half of the high-low range. When the closing price is in the lower half of the high-low range, the Stochastic Indicator reads at a level 50 or below.

The 3 Stochastics

Metatrader 4 and other forex trading platforms allow you to use two different Stochastic indicators: fast, slow.

• Fast Stochastic Oscillator – Fast oscillators use the most primary calculation which is not smoothed with a moving average. In the Fast Stochastic Oscillator, the %K, or rate of change in price, is not smoothed.
• Slow Stochastic Oscillator – The Slow Stochastic Oscillator uses moving averages on both the %K and %D calculations. The Slow Stochastic smooths the Fast %K with a 3-period SMA. The Slow %D further smooths the %D with a 3-period SMA of the %K.

Trading with the Stochastic Oscillator

As mentioned above, traders can use the Stochastic Oscillator to trade overbought and oversold levels, find future trends, or time future breakouts in volatility and momentum.

As an overbought or oversold indicator, traders should rely on the Stochastic Oscillator much like they would the Relative Strength Index. Above 80, the Stochastic Oscillator indicates that the market is overbought. Below 20, the Stochastic Oscillator reveals to traders that the market is oversold.

Divergence is particularly valuable for technical traders who use oscillators. In a divergence, the price and Stochastic Oscillator should diverge, with the price and oscillator rising or falling oppositely one another. You can see how divergence works in the diagram below: