An Big, Fat Ass Guide to a Stochastic Oscillator

There is much misunderstanding of technical indicators out there. Traders tend to use many indicators without researching or knowing what they are and how are they calculated.
Even less traders ever bother to test accuracy of indicators they use.
You would be very surprise to find out that many of them have less than 30% accuracy but you still use them!
This article will cover most important things every forex trader should know about Stochastic Oscillator

Points to cover:

1. You can use stochastics oscillator to measure the speed and momentum of a price over a time period.
2. A low value point to the strong uptrend as much as it points to a strong downtrend.
3. A high value points to the strong downtrend as much as it points to a strong uptrend.
4. Stochastic oscillator works best when used with leading indicators, chart patterns, and volume and price movement.
5. The trend following strategy can be a profitable one to use with stochastic
6. Stochastics oscillator must be paired with multi-frame analysis

Definintion:
A stochastic oscillator is a momentum indicator comparing the closing price of a security to its price range over a specific period of time.
It is one of the earliest technical oscillators in securities trading used to predict future market direction. ‘Stochastic’ is Greek for ‘random’, and in the context of trading, refers to using past actions to forecast a future state. ‘Oscillator’ refers to repetitive variations up or down the equilibrium position.
Formula
Stochastics oscillator is measured using the %K and %D lines.
%K = 100 [(C – L14) / (H14 – L14)]
C is the current closing price
L14 is the lowest price when looking back at the 14 previous trading sessions
H14 is the highest price when looking back at the 14 previous trading sessions
%K tracks the most recent market rate for the currency pair.
%D = 3 – period simple moving average of %K. It is also called the ‘stochastic slow’ due it slower reactions to market price changes compared to %K.

Stochastic Oscillator is an index compiled with recent low and high of the price and put the current price in the context in % terms.

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Characteristics

#1. Stochastic oscillator is a lagging indicator

90% of all indicators are lagging indicators, including stochastics.
It is important to grasp this concept right from the beginning. Once you understand, you will position yourself way ahead of other traders out there.
It is important to note that

stochastics oscillator is price-driven as opposed to driving the price

All indicators built into a trading platform are being computed based on price data fed into that platform. If price isn’t recorded in the trading software, the indicators cannot be populated.
There are four dimensions of the price – Open, Close, High, Low
All indicators are a different versions of the same data source.
Equation and time sets might change but the core of all of the is the same.
To easily verify this, you can go to Meta Editor in Meta Trader4
stochastic indicator 2
And open the core files of any lagging indicator you wish. After inspecting the code, you will realize they are all using difference equations but the same core data.

None of lagging indicators you are currently using are capable of predicting future price.

They simple cannot! Price is influenced by external factors, not the indicators.
Having said that, making correct judgments even some of the time can be very rewarding and
Lagging indicators can be used as a part of the analysis based on the assumption that many market participants use them hence they become self-fulfilling prophecy.
There are few very popular lagging indicators, Stochastic Oscillator is probably the most popular among traders.

#2. Overbought/Oversold levels often indicate a strong trend, not a reversal

First off, there is a wrong belief that stochastic can point to overbought or oversold levels.
A stochastic value of more than 80 might indicate a strong uptrend as often as a reversal.

There are many case studies indicating that Stochastic Oscillator more often signals a strong uptrend above 80 or a downtrend continuation below 20.

To simply test any indicator in real time you can use the visual mode “Strategy tester” within your MetaTrader4 platform.

Follow instructions below
#1
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#2
Select any of the indicators, select symbol, select timeframe, select visual mode and time period, Click start
You will now see the price action unfolding on the screen together with the indicator of your choice.
It doesn’t take long to see that Stochastic Oscillator does what we expect it to do only half the time!
stochastic indicator 4

Trader can’t blindly follow overbought or oversold rule

As you see on the screenshot below, entering long positions every time stochastic turned below 20 would ruin your account pretty quickly.

 

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Oversold levels should be also considered of an indication of a strong trend instead of a reversal signal. When there is a lot of buying or selling, it is best to follow it and not worry about the stochastic being extreme.
The price action should always prevail in your analysis.
Below is an example of strong, long term downtrend in EURUSD during which stochastic remained oversold for many weeks. Buying would not be a great idea!

 

stochastic indicator 6

#3. Stochastic Oscillator must be used in conjunction with other leading indicators

Traders use indicators for technical analysis in order to gain useful additional information. Some may use a single indicator to only make buy or sell decisions, but I advise against it.
There is no trader on this planet that made fortune in Forex by trading single indicator strategy.
Look at it this way: by using a single indicator in isolation, you’re basing your entire strategy on just that and nothing else. To get an overall view and confirm trends, reversals, momentum and volatility more accurately, you must use stochastic with other indicators, chart patterns and price movements.
Stochastic MUST an add-on to a much larger, sound trading strategy.
This is its role! Take a look at the setup below.

  1. Larger trading strategy in this example is a sound price action technique.
  2. Trader waits for the price to make higher high at B (after A)
  3. He measures the retracement by Fib. The price pulled back to 38% @ point C.
  4. The long market entry can be placed here.

Stochastic oscillator in this case serves as an additional confirmation of the reversal and plays a part within larger trading strategy.

 

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#4. It works best with the trend following strategy

Trend following signals are strong as they take the market’s own movement into account. A basic stochastic trend following signal is a signal line crossover, occurring when the %K line crosses the %D line in confirmation with the trend. When %K (short-term line) crosses below %D (long-term trend) and returns above it, you can consider it an uptrend and a buy signal. The reverse holds true for a downtrend.

Trend following is one of the most used strategies in forex trading. Stochastic can be used to enter the market on pullbacks within the trend.
Pullbacks are short-term movements that go contrary to the existing direction of the price trend.

If the market is moving above the simple market average – that is, in a bullish environment – you can consider entering long when a pullback occurs. When the price is below the average and a downtrend is on the cards, you will need to wait for short entries on pullbacks occurring in the trend.

 

#5. Always use Stochastic Oscillator on multi-frame

Sometimes traders get confused analysis markets on many time frames at the same time.

An hourly time frames may give you bearish signals but your daily or weekly time-frames may show bullish signals.

If you wait for the lower time frame to revert to the direction of the larger time-frame, the stochastic will start showing bullish signals on both charts. But this is time-consuming.
It is best to use one chart on which you will make decisions and view other timeframes to adjust your bias accordingly.
The time dimension offers more confirmation on trend lines to make smarter decisions.
Using multiframes initially can cause some confusion, but if you use them properly, you will be able to locate good entry points and make cleaner entries than if you were to use single frames.
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The above screenshot includes stochastic on a 30 minute, 4 hours and 1day chart in one window. This provides a broader reading on the market for better accuracy. Trader can line up large timeframe behavior to gain more insight. Ideal entry would be with all stochastics lined up on one side.

Download multi-period-stochastic-indicator here

Conclusion

 

There is much more to trading than just a bunch of indicators on the chart. Trader must show deep understanding of the macro markets and economics first. Indicators should be used as an additional market entry tool, a confirmation rather than a strategy itself.