The stochastic oscillator is a popular technical indicator, usually just called ‘the stochastic’ in the context of trading. It’s a momentum indicator and one of the most frequently used indicators in technical analysis. It was created by George Lane in the 1950s to compare the closing price of a commodity to a specific range over a given period of time, often 14 days.
How does the stochastic work?
The idea behind this indicator is that prices tend to close near their previous highs in up markets and near the lows in down markets. Using the stochastic with an integrated moving average can help traders to determine these trends as well as find possible points of entry and exit.
Two lines are usually calculated to assess future prices, one of which is the stochastic itself (%K) based on recent prices, often over 14 periods. The other is a moving average of recent values of %K, often for three or five periods, called %D. The comparison of these statistics is often a good indicator of the speed at which prices are changing. Stochastics also typically use a slowing or smoothing to some degree, which helps to avoid sudden spikes and plunges in price affecting readings too much.
The basic difference between fast and slow stochastics is sensitivity. Fast stochastics are more sensitive than slow, so the former usually give many more signals than the latter.
Calculating the stochastic oscillator
The reading from the stochastic is calculated as follows:
- %K = 100*(current price-lowest price for x period)/(highest price for x period-lowest price for x period)
- %D = x-period simple moving average of %K
- Smoothing = x-period SMA applied to %K
It’s important to note here that there’s no reason for you to calculate this yourself on paper. Instead, MT5 (or MT4) calculates it for you and automatically updates the readings on the chart as time progresses.
The main line, %K, is calibrated on a scale from 0 to 100. This scale is very important in determining saturation. Readings above 80 are considered overbought, and readings below 20 are considered oversold. Meanwhile %D functions as a signal line.
When %K crosses above %D, this is a buy signal or a signal to exit a selling order that’s currently open. When the opposite happens, this is a sell signal or a signal to close an open order to buy. The signal is considered to be stronger when it occurs within the ‘trigger zones’ of saturation, i.e. above 80 and below 20.
A typical fast stochastic would be set to 5, 3, 3. It gives the user many quick signals which can be helpful on lower timeframes. However, these signals are less reliable than those given by slower stochastics.
Here we can see a 5, 3, 3 stochastic on the chart of Aussie dollar-yen. Click on the image to enlarge. Some of the signals produced from crossing lines were reliable, and a trader could have used these to enter successful orders. However, many of them were unreliable.
A number of traders use slow stochastics calibrated at 14, 5, 5. Others also use 15, 5, 5, but in this case we’re taking 14 for %K as an example. This calibration as its name implies gives the trader slower and less frequent signals. That said, the signals that it does give tend to be more reliable than those from fast stochastics.
Applied to the same chart, the crossing signals of the 14, 5, 5 stochastic are more reliable in general than those of the 5, 3, 3. Click on the image to enlarge. There are still some false signals, but their number is smaller than with a fast stochastic. Nevertheless, traders should be prepared to miss some genuine signals when they use a slow stochastic.
Limitations of the stochastic oscillator
Like anything in trading and technical analysis, neither calibration is ‘perfect’ or 100% reliable. Traders using stochastics still need to confirm the signals they receive using other sources. These might include other uncorrelated indicators, price action, moving averages, Fibonacci areas or various other tools.
Equally, any technical indicator that depends on saturation can generate the temptation to ignore fundamental events. The fact is that overbought and oversold conditions can remain for extended periods when there are strong fundamental drivers of movements. As well as different indicators, traders must also consider data and news that affect prices and conditions.
Where to start?
For a beginner, a demo account with a stochastic set to 14, 5, 5, or 15, 5, 5 is the way to go. This way, you can understand and evaluate carefully all of the signals the indicator gives you across timeframes. Demo accounts are risk-free and don’t cost any money to open, so you can use one to practise and develop a stochastic-based strategy without the danger of losing real money.
Test your knowledge by trying this short quiz.
0 of 4 questions completed
You have already completed the quiz before. Hence you can not start it again.
Quiz is loading…
You must sign in or sign up to start the quiz.
You must first complete the following:
0 of 4 questions answered correctly
Time has elapsed
You have reached 0 of 0 point(s), (0)
Earned Point(s): 0 of 0, (0)
0 Essay(s) Pending (Possible Point(s): 0)
Which of these is one of the main uses of the stochastic oscillator in practice?CorrectIncorrect
Fast stochastics are generally most useful on very high timeframes like weekly and monthly charts.CorrectIncorrect
Which are the typical settings of a slow stochastic?CorrectIncorrect
It’s unreasonable to rely completely on a stochastic (fast or slow) to the exclusion of other indicators and types of analysis.CorrectIncorrect