Technical analysis is one of the three analysis types that traders leverage to predict the future performance of a security. It is the analysis type that leverages historical price performance data to predict the future outlook of a tradable asset. Within technical analysis, there are many different technical indicators that traders leverage. Oscillators form one popular category of technical indicators that are widely used in trading. In this article, we will specifically focus on describing various aspects of trading with the Stochastic Oscillator, which is considered to be one of the most reliable oscillators out there.
Stochastic Oscillator, also referred to as Stochastic Indicator, is a momentum indicator that helps determine whether a financial instrument is in an overbought or oversold condition. Structurally, the indicator consists of two lines, namely the %K line and the %D line, that fluctuate within a scale of 0 to 100. The position of these lines with respect to the indicator scale indicates the momentum and the strength of a security’s price trend.
Stochastic Oscillators, just like other momentum indicators, are leading indicators. In simple terms, it means that the indicator leads the change in actual price action by predicting when a correction in demand, supply, and price is imminent. That being said, interpreting signals from this indicator accurately and timely incorporating them into a trading plan can be a challenging task for many. Hence, in this article, we will walk through every minor detail of trading with Stochastic Oscillators, so that you can successfully integrate them into your overall trading strategy.
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Table of Contents
How to Read Stochastic Oscillator?
Even though most oscillator type indicators share similarities in appearance, they are all created using different parameters and calculations. For this reason, different oscillators have their own strengths and weaknesses and require signals generated by them to be interpreted a bit differently.
To correctly read and accurately ingest the signals generated by the Stochastic Oscillator into your trading plan, it is critical that fully understand the three topics listed below –
- Types of Stochastic Oscillator
- Construction of Stochastic Oscillator
- Stochastic Oscillator Calculations
- Interpreting Stochastic Oscillator Signals
Now, without further ado, let us dive deep into these above-listed topics.
Types of Stochastic Oscillator
In a nutshell, there are two types of Stochastic Oscillator that technical traders use in trading today. These are –
- Fast Stochastics
- Slow Stochastics
By appearance, both these variations look virtually the same, but there are considerable differences in how these two variations are calculated. Depending on your trading style and the market conditions that you are trading in, the ideal choice of Stochastics for your needs will vary.
The Slow Stochastics are known to smooth out false signals and are thus considered more reliable. That being said, the Fast Stochastics are more sensitive to changes in price trend, and thereby prove more reliable in certain market conditions.
Irrespective of the differences in how these two variations of Stochastic Oscillator are calculated, they share the same structural components, and the trading signals generated by both these variations are read and interpreted the same way.
Therefore, to conclude, even though you can choose either of the two Stochastic types depending on the market conditions that you are trading in, the overarching principle of using, interpreting, and incorporating them into your overall trading strategy will remain the same.
Construction of Stochastic Oscillator
As with all forms of technical analysis tools, Stochastics relies on historical data and patterns to make predictions on future price action.
Structurally, a Stochastic Oscillator looks similar to other oscillators and comprises of the following components –
- Two lines, known as K and D. The position of these lines on the indicator scale indicates whether a security is in an overbought or oversold condition. These lines can be calculated as either slow or fast. (More on that later).
- A Zero to 100 scale. This is the scale within which the two lines described above fluctuate.
The two lines forming this indicator are usually plotted below the price chart of a security, using the same time periods as the price chart along the X-axis, and denote readings from 0 to 100 on the Y-axis. The peaks and troughs of these two lines, K and D, on the indicator scale, lines up with the peaks and troughs of the security’s price action. Hence, their position with respect to the indicator scale offers meaningful insights in forecasting any upcoming changes in the price trend.
In summary, the Stochastic Indicator is charted below a price chart and shows the strength of price changes – the momentum. The time periods of the two charts overlap, but the price action chart indicates the actual market price of an asset, whereas, the Stochastic Oscillator lines are simply plotted in a range that is limited from 0 to 100.
Stochastic Oscillator Calculations
Stochastic Oscillator, irrespective of the type (Fast Stochastics or Slow Stochastics), comprises two lines that fluctuate between a range of Zero and 100. However, depending on your choice of Stochastics type, the calculations for two lines that form this indicator would, to some extent, vary. Therefore, to clearly understand the calculations behind both these Stochastic types, let us discuss them separately.
Fast Stochastics Calculations
There are three steps involved in calculating the Fast Stochastics. These are –
- Step-1: Calculating K Line (or %Kfast line) for Fast Stochastics
- Step-2: Calculating D Line (or %Dfast line; also known as %Kslow line) for Fast Stochastics
- Step-3: Plotting the K and the D line for Fast Stochastics
Now, without further ado, let us dive deep into all three of these above-stated steps.
Step-1: Calculating K Line (or %Kfast line) for Fast Stochastics
%Kfast line is what we refer to as the K line of a Fast Stochastics. Even though you will plot this line only when using the Fast Stochastics, it is foundational to calculating the Slow Stochastic lines as well. Therefore, calculations for this line are central to the Stochastic Indicator as a whole.
In a nutshell, the %Kfast line is plotted by taking the latest close, the highest high, and the lowest low of a security’s price over a specified length of time, and putting them into the following formula –
%K = 100 [(C – Lx)/(Hx-Lx)]
Where,
- C = Latest Close Price
- L = The Lowest Price over a specific Number of Periods
- H = The Highest Price over a specific Number of Periods
- X = Is the Number of Periods used in Calculation
Step-2: Calculating D Line (or %Dfast line; also known as %Kslow line) for Fast Stochastics
Once the %Kfast line is calculated, calculating the %Dfast line is relatively easy. The %D line is calculated using %K over three trading sessions, which are then averaged. In other words: %D is a three-period simple moving average of %K, and can be calculated using the following formula –
%Dfast (or %Kslow)= 100 [(%Kfast current period + %Kfast -1 period +%Kfast -2 periods) / 3]
Where,
- %Kfast current period = %Kfast reading for the current trading session
- %Kfast -1 period = %Kfast reading for the previous trading session
- %Kfast -2 period = %Kfast reading for the trading session before the previous session
Step-3: Plotting K and the D line for Fast Stochastics
Now that you have calculated the %Kfast line and the %Dfast line using the formulas stated in Step-1 and Step-2. In the third and the final step, you will plot these two lines on a scale of 0 to 100, and complete the Fast Stochastics plot on your price chart.
Slow Stochastics Calculations
Calculating Slow Stochastics is a bit more complex than calculating Fast Stochastics. This is because there are more steps involved in its calculations. In a nutshell, there are four steps involved in calculating Slow Stochastics. These are –
- Step-1: Calculating %Kfast line to support K line and D line calculations for Slow Stochastics
- Step-2: Calculating K Line (or %Dfast line; also known as %Kslow line) for Slow Stochastics
- Step-3: Calculating D Line (or %Dslow line) for Slow Stochastics
- Step-4: Plotting K and D line for Slow Stochastics
With that said, let us jump straight into the steps that you will need to go about in plotting Slow Stochastics.
Step-1: Calculating %Kfast line to support K line and D line calculations for Slow Stochastics
As stated in the calculation section for Fast Stochastics, %Kfast line is not plotted in the case of Slow Stochastics but is foundational to its calculations. Therefore, the first step in calculating both variations of this indicator is technically the same.
So, as already covered, you will calculate the %Kfast line using the below-stated formula, as the first step in calculating Slow Stochastics.
%K = 100 [(C – Lx)/(Hx-Lx)]
Where,
- C = Latest Close
- L = The Lowest Price over a specific Number of Periods
- H = The Highest Price over a specific Number of Periods
- X = Is the Number of Periods used in Calculation
Step-2: Calculating K Line (or %Dfast line; also known as %Kslow line) for Slow Stochastics
To put it in simple words, what is the D line for Fast Stochastics, becomes the K line for Slow Stochastics. Therefore, from the calculation standpoint, this step remains unchanged with respect to calculating the Fast Stochastics as well.
As stated above, you would use the following formula to calculate %Kslow line (also known as %Dfast line) –
%Kslow (or %Dfast ) = 100 [(%Kfast current period + %Kfast -1 period +%Kfast -2 periods) / 3]
Where,
- %Kfast current period = %Kfast reading for the current trading session
- %Kfast -1 period = %Kfast reading for the previous trading session
- %Kfast -2 period = %Kfast reading for the trading session before the previous session
Step-3: Calculating D Line (or %Dslow line) for Slow Stochastics
Calculating D Line (or %Dslow line) for a Slow Stochastics requires an additional step, as this line is not calculated needed for Fast Stochastics at all.
The calculation for the %Dslow line is similar to that of the %Dfast (or %Kslow) line. In essence, it is a simple moving average of the %Kslow (or %Dfast) line over three trading periods, and can be calculated using the following formula –
%Dslow = 100 [(%Kslow current period + %Kslow-1 period +%Kslow-2 periods) / 3]
Where,
- %Kslow current period = %Kslow reading for the current trading session
- %Kslow -1 period = %Kslow reading for the previous trading session
- %Kslow -2 period = %Kslow reading for the trading session before the previous session
Step-4: Plotting K and D line for Slow Stochastics
As stated previously, in the case of the Slow Stochastics, the %Kslow (calculated in step-2) and the %Dslow (calculated in step-3) become the K line and the D line for the indicator respectively. Therefore, in the fourth and the final step, you will simply plot these lines on a scale of 0 to 100 on the price chart. This will complete the Slow Stochastics plot on the price chart of the security that you are trading.
Interpreting Stochastic Oscillator Signals
Stochastics Oscillator is a momentum indicator and is therefore primarily used to measure the momentum of price changes. In technical trading, the term momentum is often confused with volume. Therefore, before proceeding further in this section, it is first important to understand what momentum is, how it is different from the volume, and how you can leverage it to identify opportune times for entering trades.
Momentum, as defined by John Murphy in Technical Analysis of the Financial Markets, “measures the velocity of price changes [over two-time intervals] as opposed to the actual price levels themselves”. On the other hand, the term Volume is used to represent the number of trades executed over a measured time period. Hence, Momentum is not the same as the number of exchanges or transactions over a period, which is what the term ‘Volume’ represents in technical trading.
Momentum tends to be really high when a new trend is formed. It gradually declines as the trend progresses, until a reversal in trend occurs.
In a Bullish Market, the closing price will make higher highs than in the prior periods. The gains, however big or small, will slow down before the peak is reached. In this way, when the %D line and the %K line of the Stochastic Oscillator peaks and turns down, it is a signal that momentum has changed, and prices are likely to peak soon as well.
As discussed above, the Stochastic Indicator expresses the range of a security’s price over a selected period of time on a 0 to 100 scale. This reading is the momentum.
Listed below are a few important pointers with regards to reading and comprehending momentum readings, in general. These pointers will be helpful, in the subsection that follows them, in which we cover interpreting the trading signals specifically generated by the Stochastic Indicator.
Interpreting High Momentum Readings
- With Stochastic Oscillator, high momentum is indicated on the price chart when %K is greater than 80
- High momentum indicates a bull market, with prices closing above the previous highs
- When the momentum is extremely high, the security is overbought, which could be treated as an early sign of upcoming correction in the price trend
- At high momentum, the changes in price are bigger
Interpreting Low Momentum Readings
- With Stochastic Oscillator, Low Momentum is indicated on the price chart when %K is less than 20
- Low momentum indicates a bear market, with prices closing below the previous lows
- When the momentum is extremely low, the asset is oversold, which could be seen as an early sign of upcoming correction in price trend
- At low momentum, the changes in price are smaller
Interpreting Stochastic Oscillator Trading Signals
In general, according to Murphy in Technical Analysis of the Financial Markets, oscillators signal to investors in three primary ways: [1]
- They signal an overbought or oversold indication when their signal lines extend to the furthest reaches of their Y-axis. This indicates an overextension in the price trend and signals a possible change in the trend’s direction.
- In these extreme positions, if the price action moves differently than the oscillator’s signal line, this signals an upcoming change in the trend’s direction as well. This concept in technical trading is commonly referred to as Divergence.
- Finally, when the oscillator crosses the midline of the Y-axes, it can also signal a change in trend.
When using Stochastics, the first 2 of these above-stated trading signals are very effective to prompt trades. However, crossing the midline for Stochastic Oscillators (which is at the 50% mark on the Y-axis) is not as relevant as on some other oscillators where the midpoint is 0.
For Stochastics, in particular, there are four signals that you must look for to trade profitably. Listed below are these four signal along with their interpretation –
- %D Line in the Upper or Lower 20%: When the %D line is above the 80% mark, it indicates that the asset is in an overbought condition. Similarly, a below 20% mark reading of %D Line signals that the asset is oversold.
- %K Line (faster line) crossing the %D Line (slower line): Crossover between the %K line and the %D Line works similar to the moving average crossovers on the price chart. When the %K line crosses above the %D line, it indicates that the asset’s price is gaining positive momentum, and it, therefore, serves as a bullish signal. Similarly, when the %K line crosses below the %D line, by the same but opposite reasoning, it is treated as a bearish sign.
- Rise and Fall of %D Line: A rising %D Line indicates a growth in the bullish sentiment for the security. Similarly, a fall in %D Line indicates growing bearish sentiment. When this signal line is near an extreme reading on the Stochastics scale and begins to rise or fall, it can be treated as an early sign of an upcoming correction or reversal.
- Divergence between %D Line and Security’s Price: In simple terms, Divergence means that the trend in price is not in agreement with the trend in %D Line. At a high level, this Divergence indicates a decline in the momentum of the price change and represents a weakness in price trends. Hence, when it appears on the price chart of a security, it can be treated as an early sign of upcoming reversal.
Of all the above-stated trading signals that one can extract using Stochastic Oscillator, Divergence is considered to be the most reliable one. In fact, George Lane, the creator of Stochastics Oscillator, himself said – “there is only ONE valid signal. That signal is a divergence between %D and the stock with which you are working”.
Finally, as a closing note to this section, I would like to remind you that just like any other technical indicator, the Stochastic Oscillator will produce many trading signals, and not all of those will be profitable. Therefore, you must learn how to filter through the inaccurate signals produced by Stochastics and take only the trades that have a high-profit probability. Some tools and techniques to do the same are discussed in the next section.
Improving Reliability of Stochastic Oscillator in Trading
Stochastic Oscillator is considered pretty reliable as an oscillator. However, as mentioned above, it generates many signals and not all signals produced by it are profitable. Therefore, to effectively integrate this indicator into your overall trading strategy, you must know how to filter through the inaccurate signals produced by it.
Additionally, even though Stochastic Oscillator can be leveraged to improve the accuracy of your trades in combination with other indicators and trading tools, it is rarely effective as a stand-alone indicator.
Given these above-stated limitations, to use Stochastics effectively, you must learn how to improve the reliability of its trading signals. Listed below are four popular ways to improve the reliability of Stochastic Oscillator in technical trading –
- Adjust Time Period to Change Sensitivity
- Raise and Lower Overbought/Oversold Threshold to 85/15
- Combine Two Stochastic Oscillators
- Combine Stochastic Oscillator with Other Indicators and Tools
Now, without further ado, let us briefly discuss each of these four methods to improve the reliability of the Stochastics Indicator.
Adjust Time Period to Change Sensitivity
Adjusting indicator settings is one of the easiest and popular methods for improving the reliability of the Stochastic Oscillator in trading. Under default settings, the indicator is set to calculate the %K Line over 14 trading sessions. However, depending on your trading conditions, you might want to make adjustments to this setting to modify the indicator’s sensitivity, and thereby improve its reliability.
Described below are broad level guidelines to adjust the sensitivity of Stochastic Oscillator using the time period input in indicator settings –
- More Periods – Fewer but Stronger Signals: As already mentioned, the default settings for %K’s calculation that Stochastics use is 14 trading sessions, and the %D line is calculated by using three smoothing periods. To improve the reliability or the strength of the trading signals generated by the Stochastic Indicator, you can increase the trading session parameter for %K calculations to a higher number. However, in doing so, you must remember that the frequency of the signal generation will take a considerable toll.
- Fewer Periods – Responsive Signals (more false signals): There are situations in trading where you would want your indicator to be more sensitive to changes in price than what the default indicator settings would allow. In such trading scenarios, you can increase the responsiveness of the Stochastic Indicator by decreasing the number of trading sessions over which %K line is calculated. An example of such a trading scenario where you would want your indicator to be more sensitive would be when you are scalping or day trading a highly volatile asset.
Additionally, you could also chart both the fast and the slow stochastics (one below the other, under the price chart) to compare the indicator sensitivity and assess the accuracy of the trading signals.
Raise and Lower Overbought/Oversold Indicators to 85/15
In default configuration, when trading with a Stochastic Oscillator, a Stochastic reading above the 80% mark is considered as a signal to an overbought condition. Similarly, under default configuration, a Stochastic reading below the 20% mark, signals an oversold condition.
In trading with the Stochastic Indicator, you would do fine in most trading conditions with the above-stated default configuration. However, to improve the accuracy of the overbought and the oversold signals from this indicator, you can take a more conservative approach.
In doing so, you can increase the threshold for an overbought signal to the 85% mark, and reduce the threshold for the oversold condition to the 15% mark. This will limit the frequency of trading signals generated by the indicator and only the more reliable signals will pass your screening.
Even though this strategy can be effective at improving the reliability of the Stochastic Indicator, in adopting this approach you must remember that several opportunities to profit from the market will be missed. Therefore, you must judiciously choose when to pull in and out of such conservative trading approaches for sustained and profitable trading.
Combine Two Stochastic Oscillators
One way to improve the reliability of Stochastic Oscillator in trading is to use more conservative indicator settings when determining the direction of the trade, and a relatively relaxed setting when determining trade entries. In doing this, you essentially get the best of both worlds.
- First, with conservative settings for determining the direction of your trades, you minimize the risk of the market moving against you.
- Second, with a relaxed setting for determining trade entries, you don’t miss out on any potential trade entries.
While this above-stated approach works great in principle, applying it to your trading can be challenging, especially if you day trade or trade on a smaller time frame. This is because when you trade in real-time, changing indicator settings time and again, will prove to be no easy feast. Therefore, to get the same effect, but in a scalable and timely manner, you can use a Two Stochastic Oscillator Setup on your trading chart, instead of one.
You can set one of these indicators in conservative settings, and use it to determine the direction of your trades. Similarly, the other indicator, with slightly relaxed settings, will guide you through the most opportune times to enter or exit trades.
In this Two Stochastics Setup, the exact settings for the two indicators that you should use would depend on numerous factors such as the asset class you are trading in and its volatility. To perfect a setup that best meets your trading needs would require a lot of experimentation using trial and error methods. However, as a starting point, using a 21 period setting for the conservative Stochastics and an 11 period setting for the trade entry stochastics should meet your requirements in most market conditions.
Combine Stochastics Oscillator with Other Indicators and Tools
As stated earlier, Stochastics Oscillator is an impressive trading tool, but it can rarely be leveraged as a stand-alone indicator. Therefore, to make the most reliable trades using Stochastics Indicator, it is best used in combination with other technical indicators and tools in technical analysis.
Listed below are examples of several tools and indicators in technical analysis that best complement the signals produced by Stochastic Oscillator, thereby improving its reliability –
- Relative Strength Index (RSI)
- Candlestick Patterns
- Support and Resistance
Now, let us briefly discuss how each of these tools can be leveraged to improve the reliability of the Stochastic Indicator.
Relative Strength Index (RSI)
Similar to the Stochastic Oscillator, the Relative Strength Index is another popular momentum indicator that is used to determine if a financial instrument is in an overbought or oversold condition.
Even though both RSI and Stochastic Indicators serve a similar purpose in trading, the method or the underlying calculations used by both these indicators to flag overbought or oversold conditions is very different. Hence, you can leverage signals from the Relative Strength Index (RSI) as a sign of confirmation for the trades identified using Stochastics.
When the trends or readings in RSI complement the indications from Stochastics, you can be rest assured that the trading decision that you are looking to make is the one with a high success probability.
Candlestick Patterns
Candlestick Patterns are among the most popular forecasting tools in technical analysis that traders use today. There are many different types of Candlestick Patterns, but at a high level, all of these patterns can be clubbed into two categories. These are –
- Reversal Candlestick Patterns
- Continuation Candlestick Patterns
Described below is how each of these two candlestick pattern types can be leveraged to improve the reliability of trading signals from the Stochastic Indicator.
Reversal Candlestick Patterns
As the name suggests, Reversal Candlestick Patterns are the patterns that indicate an upcoming reversal in price trend. When the overbought or the oversold reading from Stochastic Oscillator coincides with the appearance of a Reversal Candlestick Pattern, it means that the likelihood of a reversal in the current trend is strong. Therefore, you can use Reversal Candlestick Patterns as a confirmation signal when deciding to make reversal trades using the Stochastic Indicator.
Continuation Candlestick Patterns
Continuation Candlestick Patterns, staying true to their name, indicate a continuation in the existing direction of the trend. Therefore, when looking to enter a reversal trade using signals from the Stochastic Oscillator and you see a Continuation Candlestick Pattern on the price chart, it should be seen as a sign of caution and you should avoid taking such a trade.
Contrarily, when Stochastics gives you an indication to enter a trade in the direction of a prevalent trend, you can treat the appearance of a Continuation Candlestick Pattern as a confirmation signal for that trade.
Support and Resistance
Support and Resistance are the regions on the price chart of a security, where the likelihood of a trend reversal is high. In essence, these levels indicate the region of high demand and supply for security.
When the price of the security falls to a support zone, with abundant demand at that price point, the buyers for the security rush into the market, and consequently the price of the security begins to rise. Similarly, when a security’s price hits a resistance zone, the holders of the security rush to book profits and start selling, and as a result security’s price begins to fall.
Therefore, if the overbought or the oversold signals generated by the Stochastic Indicator coincides with the presence of a Resistance and Support level respectively, it indicates that the success probability of that reversal trade is high. Hence, you can trade reversals with confidence when your trading strategy revolves around the confluence of Support and Resistance Levels and Stochastics.
How to Trade Using Stochastic Oscillator?
Now that we have covered the construction, the calculation, and the interpretation of the Stochastic Oscillator, alongside various methods and tools to improve its reliability, it is now the time to put that knowledge to work and discuss a few strategies to trade using this indicator.
Even though Stochastic Indicator can be incorporated into many different trading strategies, it is found to be particularly useful in the following two strategies –
- Divergence Trading Strategy
- Overbought/Oversold Trading Strategy
The trading signals from the indicator are easy enough to spot, but with these above-listed strategies, you can accurately assess the significance of the indicator signals and take appropriate action.
Trading Strategy 1: Divergence Trading Strategy
Divergence is the term used to describe situations where the signals from an oscillator, such as a Stochastic Oscillator, diverge from the actual price action on the price chart.
In simpler terms, when the price of a security makes a higher high, but the corresponding reading on the Stochastic Oscillator is either flat or lower in comparison to the reading before, this misalignment between the actual price action and the indicator reading is called Divergence. The same principle holds true when the price is making lower lows and the Stochastic readings are not in alignment with those lower lows.
In a nutshell, Divergence indicates a reduction in momentum and a growing weakness in the price trend. It is therefore regarded as an early sign of an upcoming reversal and is invaluable in identifying reversal trades.
Discussed in the following sections are some guidelines to implement Stochastic Oscillators in identifying trade entries, stop-losses, and take-profit targets within the Divergence Trading Strategy.
Determining Trade Entry
To determine trade entry using the Stochastic Oscillator under the Divergence Trading Strategy, you must first learn how to identify Divergence on the price chart using this indicator.
In the case of a Stochastic Indicator, the %D Line (or the slower line) is used to identify a divergence between indicator readings and the actual price action. That is to say, if the %D line of the Stochastic Oscillator moves in the direction that is opposite to the price action line, you have divergence confirmed on the price chart.
With that principle noted, below are the two signals that you would look for when trading Divergence using the Stochastic Indicator –
- A bearish signal, which occurs in a bull market, comes when the asset price peaks, dips, and then peaks higher – while the %D peaks, dips, and then peaks lower than the first peak. This is the signal to get ready to sell as a downturn is expected.
- A bullish signal, which occurs in a bear market, comes when the asset price makes a low, a small bullish rally, and then drops even lower – while the %D makes a low, a rally, and then a higher low. This is the signal to get ready to buy as an upward reversal is likely.
To affirm these signals, you may want to wait until the oscillators diverge outside the resistance (80% mark on the Y-axis) or the support (20% mark on the Y-axis) level. Additionally, once the divergence has occurred, you should wait until the %D moves back within the normal trading range (from 21% to 79%) to execute a trade.
Finally, the accuracy of your trade entries with the Divergence Trading Strategy can increase multifold when you combine them with reversal signals from other complimentary trading methods, such as – Support and Resistance, Candlestick Patterns, etc.
Therefore, I would highly recommend that you always trade these above-stated Divergence signals, alongside other techniques in technical analysis.
Determining Stop Loss Target
Generally speaking, Divergence is a very strong signal for declining momentum in a price trend and is considered very reliable for forecasting upcoming reversals in price trends. However, the timing of that reversal is something that Divergence provides little information on.
Even with a declining momentum, a trend can continue its prevalent direction for a while, resulting in massive losses for the traders that bet on an upcoming reversal in trend. Therefore, just as with any other trading strategy, proper risk management is vital for trading Divergence.
Stop-loss targets can only be set at specific prices, not at points on the oscillators’ scale because the oscillator is measured in percentages, not in monetary terms. Therefore, to determine stop-loss for trades entered under this strategy, you will primarily need to rely on signals generated by tools other than the Stochastic Oscillator.
Listed below are examples of several tools that be leveraged to determine stop loss when entering trades using this strategy –
- Support and Resistance: As stated above, the Support and Resistance levels are the regions on the price chart where the probability of reversal is high. Therefore, when taking a bullish trade using divergence, you would put your stop loss a few points under the nearest identified support level. Similarly, in the case of a bearish trade, you would put your stop loss a few points above the nearest identified resistance level.
- Fibonacci Retracements and Extensions: The Fibonacci Retracements and Extensions work similar to the Support and Resistance levels. These levels are calculated using the Fibonacci numbers, and similar to the Support and Resistance levels, represent the areas on the price chart where the probability for trend reversal is the highest. Therefore, depending on the direction of your trades, you can place the stop loss for your trades a few points above or below the Fibonacci Retracement or Extension level that is nearest to your trade entry.
In addition to these above-stated examples, the Trailing Stop Loss is another effective way to manage Divergence trades, once the reversal has occurred and the price gets some initial traction in the anticipated direction.
Determining Take Profit Target
With the Divergence Trading Strategy, there are several different approaches that you can take to determine the take profit targets for your trades.
- When trading conservatively, it is advised that you exit divergence trades for profit, once the %D line reaches the 50% mark. This is because the 50% mark, at the midline of the Stochastic scale, represents the neutral momentum region.
- If you want to trade more aggressively, you can exit a bullish trade for profit once the %D line crosses the 80% mark on the Stochastic scale. Similarly, a bearish trade can be closed for profit when the %D line hits the 20% mark on the Stochastic scale.
Finally, in addition to the above-stated techniques, you can also rely on trading signals from complementary indicators and tools, such as the Support and Resistance levels, to determine the take profit targets for your trades.
Trading Strategy 2: Overbought/Oversold Trading Strategy
Overbought/Oversold is perhaps the most basic, yet effective, trading strategies that technical traders leverage Stochastic Oscillators for.
As stated above, when the %K, and more importantly %D, cross above 80% or below 20%, the market can be said to be overbought or oversold, respectively. Being overbought or oversold is considered an early sign for a potential correction or a reversal in price trend. It is based on this principle that this trading strategy is primarily based.
In addition to that, you must also note that similar to the Divergence Trading Strategy, the Overbought/Oversold trading strategy also yields the best results when used in combination with other complementary trading methods. Hence, it is best that you leverage the Stochastic Oscillator as one part of this strategy and not make trading decisions solely based on the momentum readings from this one indicator.
Now, without further ado, let us discuss how you would enter and exit trades under this strategy leveraging the Stochastic Oscillator.
Determining Trade Entry
With the Overbought/Oversold Strategy, the idea is that you enter a bullish trade when the security is Oversold, and sell or short-sell the security when it is Overbought.
Hence, with that principle in mind, below is how you would enter a trade under this strategy –
- Sell or short-sell the security when the %D dips below 80, after being above 80, as it signals a potential downtrend in making. For added confirmation, you can wait until the %K line crosses below the %D line before entering a sell trade under this strategy.
- Enter a bullish or a long trade when the %D rises above 20, after being below 20, as it signals an emerging uptrend. For more conservative or risk-averse trade entries, you can wait further until the %K line crosses above the %D line for making a bullish trade entry.
Finally, as stated before, this strategy usually works best when combined with other trading strategies, including the Divergence Trading Strategy described above. Therefore, for consistent success, you must avoid making a trade decision solely based on the Overbought and Oversold signals.
Determining Stop Loss Target
When the Stochastic reading rises above the 80% mark and then falls below 80, a trader following the Overbought/Oversold strategy will have gone short on his position under the assumption that the price will soon fall.
However, if that does not happen, a re-entry of the %D Line above the 80% mark would indicate the point at which one should pull the plug and exit the trade to cut his/her losses.
Similarly, post a bullish trade entry is triggered, in case you see no reversal in price trend and the %D Line falls below the 20% mark again, it signals that your trade setup is invalidated and that you should exit the trade to cut your losses.
Determining Take Profit Target
With the Overbought/Oversold Trading Strategy, there are multiple approaches that you can take for determining the Take Profit targets for your trade. In doing so, you can either rely on the trading signals generated by the Stochastic Indicator alone, or leverage signals from other methods in technical analysis.
Listed below are two popular methods for setting take profit levels using signals from the Stochastic Indicator alone under the Overbought/Oversold Trading Strategy –
- Irrespective of whether you have taken a buy or a sell trade, exit it for profit when the %D line on the indicator hits the 50% mark. Since this midline mark on the indicator scale represents a phase of neutral momentum, it is a good point to book profits for risk-averse traders.
- For traders with a higher risk appetite, exiting a bearish trade when the %D line enters the oversold region, and exiting a bullish trade when the %D line enters the overbought region on the indicator scale would be another alternative to determine the take profit levels.
Additionally, as mentioned above, there are several other tools in technical analysis that can be leveraged to determine the take profit targets under this strategy. The most popular of such complementary tools are listed as follows –
- Fibonacci Retracement and Extension Levels
- Pivot Points
- Candlestick Patterns
- Chart Patterns
Day Trading With Stochastic Oscillator
With the advent and popularity of apps such as Robinhood and Acorns, and with the growing presence of phone apps from Charles Schwab and Fidelity, day trading has become a new career for many.
A general rule of thumb for trading short term using oscillators is to use shorter or fewer time periods to measure momentum.
For Stochastic Indicator in particular, when day trading, set fewer periods measuring ten, seven, or even five highs and lows, rather than the typical 14 for %K Line calculations. This will lead to more fluctuation in Stochastic readings on the price chart, and thus signal more trading opportunities which you would have otherwise missed.
Moreover, in addition to the indicator settings, the price charts in itself should be set to measure shorter, intra-day, price changes, when you are looking to buy and sell securities within a day.
A typical day trading strategy involving a Stochastic Oscillator is to find a trading signal on the weekly chart, then move to a daily chart and see if the signal is still there. If the trading signal is still present, you then move to the 4-hour chart, and then to hourly, and then even down to the 15 minutes price chart. If the signal continues to exist on all timeframes, you then pull the trigger and enter the trade using a Stochastic Indicator.
Advantages and Limitations of Trading Stochastic Oscillator
Stochastic Oscillator is a very powerful and dependable trading tool, but it does come with its own set of advantages and limitations.
To effectively trade using this indicator, it is important that you understand the major pros and cons of relying on Stochastics and factor them into your overall trading strategy.
For that reason, let us discuss some prominent strengths and weaknesses of this indicator in the following sections.
Advantages of Trading Stochastic Oscillator
Listed below are several key advantages of trading with the Stochastic Oscillator –
- Stochastic signals are easy to spot, analyze, and comprehend for traders at all experience levels.
- It is relatively easy to integrate signals from the Stochastic Oscillator into your overall trading strategy.
- Stochastic signals can help identify the overbought and oversold conditions in the market, and can therefore help traders make informed trading decisions.
- Divergence is a powerful signal that can be extracted from Stochastic readings. Interpreting this accurately can provide traders with the much-needed edge in identifying reversals.
Limitations of Trading Stochastic Oscillator
Listed below are several key limitations of trading with the Stochastic Oscillator –
- Stochastics work great in combination with other complementary indicators and tools but can prove unreliable as a stand-alone indicator.
- Stochastic Indicator often produces false trading signals, especially in highly volatile market conditions.
- In comparison to other oscillators and momentum indicators such as the Relative Strength Index, trading signals from the Stochastics Indicator can visually appear more complex.
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Conclusion
Stochastic Oscillator is a very powerful technical indicator that is primarily used to determine whether an asset is overbought or oversold, and is consequently very popular in most technical trading circles. Even if one chooses not to use it, to be proficient and fluent in technical analysis, one should be familiar with its construction and implementation.
Stochastic readings can indicate the momentum and the significance of price changes, and can thereby help traders identify the final peak or trough of a bull or bear market.
While very powerful in combination with complementary indicators and tools, Stochastics can rarely be used as stand-alone indicators for making profitable trades. You should therefore be familiar with other tools in technical analysis that can complement and boost the reliability of trading signals from Stochastic Indicator.
Finally, as is the case with any investment, you must continue research, explore, and experiment with Stochastic Indicator trading strategies to identify the trading methods that best meet your individual trading needs. If you are unsure about what you are doing, seek the advice of an expert, such as a certified financial planner, or consult with your broker before committing any meaningful capital in technical or fundamental trading.
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