Understanding Stochastic Oscillator. How to apply and adjust stochastic oscillator to trade on Forex

A stochastic oscillator is one of the most essential tools for determining market entry points. This momentum indicator measures market movement based on an asset’s price history and gauges an overbought or oversold market condition.

Trading strategies that involve the stochastic oscillator are suitable for novice traders as these strategies are easy to grasp. Savvy traders prefer to use the stochastic oscillator instead of other indicators because of its versatility, compatibility with other technical analysis tools, and relatively high accuracy.

This article discusses how the stochastic oscillator operates, provides the best settings for using it, and describes the characteristics of buy and sell signals it generates. You will discover how to use the stochastic oscillator in trading. The article also provides examples of trading strategies, trading styles, and time frames that perform better in tandem with this momentum indicator.

The article covers the following subjects:

Major takeaways

Main terms and concepts	Conclusions and key points
What a stochastic oscillator is	It is a technical analysis indicator that shows the correlation between an asset’s particular closing price and a range of its prices over a certain period of time.
Why using a stochastic oscillator	It determines trading patterns: extremes, trend movement, market reversals, giving overbought and oversold trading signals.
Signals	Mostly, it gives reversal signals. An overbought or oversold market precedes a correction. Divergence and convergence appear before major market reversals.
Settings	The default settings are 5.3.3. In volatile markets, traders use stochastic settings of 8.3.3 or even 14.3.3.
What a stochastic oscillator measures	The indicator compares recent prices to the previous averaged prices and displays this measurement on a scale of 0 to 100. Values below 20 indicate that the market is oversold, and values above 80 point to an overbought market condition.
Trading strategies	An overbought/oversold threshold strategy, a 50-level crossover strategy, scalping, a day trading strategy, swing trading, and others.
Time frames	Applicable to any time frame.
Advantages and disadvantages	Advantages: Stochastic generates a lot of signals, it is available in almost all trading and analytical platforms by default. It can be included in any trading strategy. Disadvantages: It should be combined with other indicators. The indicator’s settings significantly influence its performance. It does not take into account fundamental analysis. Stochastic may give false signals. In addition, signals may be delayed, as the indicator follows the price.

What Is Stochastic Oscillator?

First, let’s have a look at the definition of a stochastic oscillator.

A stochastic oscillator is a technical momentum indicator that compares an asset’s current prices with a range of its prices over a certain period of time.

This tool determines trading patterns:

The stochastic oscillator accounts these patterns in its calculations. In upward trends, the current closing price hovers at previous swing highs for some time. On the flip side, the price temporarily stays at previous swing lows during downward trends.

The indicator can be applied to any market when using the appropriate time frame and settings.

How Does the Stochastic Oscillator Work?

Classically, a stochastic oscillator as a technical analysis tool is represented by two moving curves that move between two levels. Usually, these are 80% and 20%.

The solid orange line in the image above is called %K, and the blue line is the 3-period moving average of the %K curve.

When two lines are above the upper level of 80% (marked with blue zones at the top), the instrument is overbought. When they fall below the bottom horizontal line of 20% (red zones in the bottom), it’s oversold. This is how the user can easily spot the overbought and oversold levels of the market.

Line crosses have a special meaning. If it happens in the overbought zone, it’s a signal of a short position. If it is in the oversold area, you should open a long trade to avoid losing money rapidly.

Nevertheless, it’s not recommended to trade using only the stochastic oscillator as a momentum indicator. In the simplest stochastic oscillator strategy, signals are filtered by the trend direction. For instance, if a downtrend prevails, open only short positions. If there is an upward trend, place long trades. Combining a stochastic indicator with other trading tools can help the user to spot easier overbought and oversold conditions.

Thus, if we analyze the overbought and oversold levels of the EURUSD chart, we can spot a bearish trend. That’s why we look for a point to open a short trade in overbought zones. The stochastic oscillator presents a potential entry point where the red oval is. As there is a crossover of the indicator lines above 80%, a short-term correction should end, and the downtrend will continue pushing the oversold levels lower.

Stochastic Momentum Index (SMI) Explained

In addition to the classic stochastic indicator, a modified version called the Stochastic Momentum Index indicator, or SMI, is widely used. It is also considered a very efficient technical analysis tool that combines the aforementioned tool with momentum, which provides smoother signals and is less dependent on market noise.

In SMI, curves are built around a zero line and move in either a positive or negative direction. One of the curves is called smoothed or fast; another one is short-term. As you can guess, these lines differ by period.

Some of the stochastic momentum indicator’s pros are its reliable entry and exit signals when the market is flat. Still, even in such a case, it’s worth using the SMI with other technical tools. As for the directional movement, the SMI uses the last closing price and provides plenty of fake signals.

You can download the Stochastic Momentum Index here.

The standard installation process is via MetaTrader 4. For beginner traders, check the step-by-step explanation using the example of the Bollinger Bands indicator here.

Install and run the stochastic indicator. In the “Input parameters” tab, you can change parameters such as:

• «Period_Q» – a period of the algorithm’s primary curve;
• «Period_R» –  primary smoothing of the main line;
• «Period_S» – secondary smoothing of the main line;
• «Signal» – the parameter responsible for the smoothing of the secondary signal curve.

If both the main and signal curves (the green and red lines on the chart above) are above the zero line (blue), the market is overbought; if below, the market is oversold. This way the user can always have a better understanding of the overbought and oversold levels of the market.

A sell signal is formed when the main momentum indicator line crosses the signal line upside-down.

On the chart above, the red arrow marks this moment. If the stochastic indicator breaks the signal line bottom-up (green arrow), open a long position. A stop-loss can be placed slightly below local minimums within several candles from the entry point. Close the position at either a take profit level, which is 2-3 times bigger than stop-loss, or when a reversal signal occurs in order to avoid losing money rapidly.

Best Settings for Stochastic Oscillator

Let’s dig deeper into how the indicator works to get the best settings for it. Traders use the following stochastic types:

• the fast stochastic oscillator includes two lines: the solid main line %K and the dashed signal line %D;

• the slow stochastic oscillator is less volatile, showing less market noise. It replaces the %K line with the %D line and the %D line with a three-day moving average equal to %D. If you set the smoothing period to 1, you will plot the fast stochastic oscillator.

The stochastic oscillator includes three parameters:

• %K period;

• %D period;

• smoothing period.

   

The default settings in MetaTrader and most other trading platforms are 5.3.3. For day trading, these are the best indicator settings, providing optimal sensitivity and noise level.

The chart above shows the indicator with default settings 5.3.3. As can be seen on the chart, the indicator with such parameters generates a lot of overbought and oversold signals, and its lines are not smooth enough, which indicates excessive volatility.

To analyze volatile charts, traders prefer to use stochastic oscillators with settings 8.3.3 or even 14.3.3, which give fewer false signals.

The stochastic oscillator with settings 14.3.3 is added to the EURUSD chart. Unlike the previous example, the indicator’s lines are smoother. The algorithm takes into account a wider price range over time, which means that reversal signals appear less often, generating fewer false signals.

If we consider the indicator’s general settings, we can draw a simple conclusion: Higher values make the stochastic oscillator less sensitive to market noise, and low values make it over-sensitive. In this regard, the frequency of signal occurrence changes.

The picture above shows an example of using the stochastic oscillator with periods 3.3.1, which excludes smoothing. With such settings, the indicator line changes direction along with the price. This means that it reacts to the slightest price movements.

Traders should tune their stochastic oscillator for the markets they trade in, considering time frames and preferred trading styles. Ready-made trading strategies with stochastic oscillators usually include recommendations for indicator settings.

It is possible to use the tool with other technical indicators such as MACD, RSI, or ADR. When used together, the settings of the used indicators can be adjusted depending on the trader’s goals, chosen stochastic oscillator’s settings, and the trading strategy.

Stochastic Indicator Calculation & Formula

Let’s consider the stochastic oscillator’s formula.

%K is calculated as follows:

Where:

• max (Hn) – a top within an n period;
• min (Ln) – a low within an n period;
• C0 – a close price of the current candlestick.

Here’s an example of the Stochastic’s formula that uses three periods.

On the chart, the bar with which we calculate the stochastic indicator is marked with green. The close price is 1,17972. The green line highlights the highest price for the last three candles – 1,17994. The red line marks the lowest price of the previous three candles, which is 1,17948.

According to the stochastic indicator’s formula:

%K = 100 * ((1,17972 – 1,17948)/1,17994 – 1,17948) = 100 * (0,00024/0,00046) = 52,17%

This is how traders used to calculate stochastic readings and used to define the highest and lowest prices. Nowadays, it seems extremely inconvenient.

Alternatively, you can use an automated stochastic indicator, which is integrated into the LiteFinance online platform, MetaTrader 4, or download the stochastic oscillator as an Excel calculator here. The principle of how this calculator works is straightforward. It is like the Excel Bollinger Bands Table (the link to the explained instructions is here).

Stochastic Indicator Interpretation: Reading the Charts

When using the stochastic indicator on Forex trading, there are many signals, including the overbought and oversold levels of the market. That’s why this momentum indicator is often used with other indicators for more accurate signals. In the following sections, we will explain the specifics of the stochastic oscillator signal types, methods of interpretation, and detection.

Fast, Slow & Full Indicators

How do you set the stochastic indicator? Usually, the parameters are defined by three meanings. One for each % K, % D, and smoothing coefficient. 5, 3, 3 is one of the classic combinations.

Where:

•  5 is a period of %K- the leading stochastic curve. As you might remember, we have already broken down how to calculate this parameter. The stochastic formula looks like this:

The value 5 means that maximums and minimums will be calculated for the last five candles. In the stochastic indicator’s formula, this parameter is presented by n.

• 3 reflects the period of %D, a so-called signal line. It’s a simple moving average built on the final parameters of %K.

• 3 is the last parameter of the slow stochastic oscillator. It’s used to smooth the %K curve, making it more flowing without market noise. In other words, initial %K is calculated with an averaging coefficient.

In such a case, the formula for %K is as follows:

The %D curve will be built on the average value of %K. In fact, it will be double smoothed. Such an effect allows you to filter noise and reduce the number of fake signals, but it also increases the stochastic oscillator’s lag. That’s why it’s called slow.

If you don’t want to use smoothing, you should use 1 as the last parameter. Such stochastic indicators are called fast.

The full version of the stochastic oscillator allows you to change all three parameters and even how %D stochastic is smoothed.

LiteFinance gives you the chance to experiment with a free demo account, but also provides the full version of the indicator. But if I could, I would call it Super Full Platform provides such comprehensive settings.

LiteFinance supports four types of smoothing the stochastic oscillator:

• Simple is classic smoothing and uses a simple moving average (SMA);

• Exponential smooths using an exponential moving average (EMA);

• Linear Weighted smooths using Linear Weighted Moving Average (LWMA);

• Smoothed is double smoothing due to the feature of the Smoothed MA (Smoothed MA).

Such functions allow the user to make use of the stochastic oscillator formula in any trading tool and market, in order to spot easily the highest and lowest prices of the market when trading cfds, currency pairs, etc. There are no strict rules on what smooth settings to use with this momentum indicator, but it’s vital to consider their differences for successful trading experiments.

Let’s visually compare how they differ.

In the case we trade forex, like the price chart above, the numbers can correspond to five signals of the stochastic oscillator.

It’s clear that the second and fourth signals are fake. The first and fifth ones reflect the local correction. The most valuable signal is the third one, which indicates a trend reversal, in some points protects the trader from losing money rapidly.

Note! Here, the signals are a cross of %K and %D lines above 80% and below 20%. Later, we will talk about momentum indicator signals in detail. Now, it should be remembered as a condition for the experiment.

On the chart above, the stochastic oscillator takes various forms such as:

1. Fast;

2. Slow with an SMA;

3. Slow with an EMA;

4. Slow with an LWMA;

5. Slow with a Smoothed MA.

Periods for all stochastics are similar: %K – 5, %D – 3. A smoothing period for all types except fast stochastic is 3.

Conclusions:

1. A fast stochastic oscillator is a momentum indicator that reacts to the market movements faster than other types. It operates almost without a delay, but the number of fake signals is large leading investors on losing money rapidly.  

2. Using a slow stochastic oscillator with SMA and LWMA is almost identical regarding the lag and number of fake signals.

3. The filter of the slow stochastic indicator with Smoothed MA was too strong and suppressed almost all signals. It provided only the last alert out of five.

4. The most effective slow stochastic was the one with smoothing EMA. This indicator successfully filtered fake signals and was slightly faster compared to its counterparts.

We tested the signals on the M30 chart of the EURUSD pair. Still, results may vary on other timeframes and trading instruments. You can compare any type of stochastic indicator using a free demo account right now on LiteFinance in several clicks without registering.

Timeframes also play an important role. The best stochastic oscillator settings for М5, М15, М30, and, sometimes, H1 timeframes are (10,7,3), (7, 3, 3), or (5, 3, 3). On high timeframes, such parameters may generate false signals. Therefore, stochastic oscillator settings for H4, D1, and, sometimes, H1 charts are (9, 3, 3), (14, 3, 3) or (21, 3, 3).

You can use slower curves with (21, 7, 7) or (21, 14, 14) settings for daily and weekly charts. The described setting combinations are used most often. You can practice and pick up your own parameters. Maybe you will succeed and find a perfect combination for your stochastic strategy.

Crossovers

The crossover between the %К and %D curves is the leading signal of the stochastic oscillator tool. It’s analyzed only in overbought and oversold zones analyzing the current closing price. In other cases, such signs are useless.

There are two types of crossovers:

• When the %K line curve breaks above the %D line, the trend is bullish. In this case, it’s worth placing a pending order slightly above the cross point.

• When the %K curve crosses the %D line upside-down, strong sell signals are monitored meaning that a bearish trend begins. A short position should be open slightly below the breakout point.

Below I will show how to use the stochastic oscillator by spotting the overbought and oversold conditions on the EURUSD chart.

Above the green oval, you can see an upward cross of %K and %D lines. Since the signal occurred below 20%, the risk of it being false is low. Here, it’s worth opening a long trade near the highest point of the crossover candlestick. On the chart above where the lowest prices are, I marked the entry level with a green line.

Here, we observe the opposite situation. A %K line curve crosses the %D one downwards at a price range, slightly above 80%. Therefore, analyzing the behavior of the stochastic lines, we can open a short position near the close price of the candlestick where the cross happened.

At the same time, a small shift down is acceptable. In the chart above, this situation is marked with a red oval.

Overbought & Oversold

The stochastic oscillator can help the user to have a better understanding of the overbought and oversold conditions of the market. The overbought issue occurs within an uptrend when the main line crosses the 80% level in an upward direction. It’s a sign that the rise slows down, and the price trend reverses down. Generally, a sell position should be open when the line breaks the 80% level back from the top, where the last closing price is, and follows the downward direction.  

Oversold conditions happen in the downtrend when the line falls below the 20% level. In a similar fashion, it signals a slowdown of the price decline and that there is about to be a reversal. It’s recommended to buy when the curve exits the oversold area crossing the 20% line bottom-up.

When analyzing the indicator’s behavior in overbought or oversold zones, it’s worth considering the reversal’s formation in order to spot a potential buy or sell signal. If the primary curve forms an acute angle, the following price movement will be intense. If the repeated break occurs after flat conditions, the move will likely be weaker but stable.

Using the stochastic oscillator on the chart, blue squares indicate overbought areas; red ones mark oversold zones. In all three cases, those major signals show that the price tends finally to be reversed. The right blue square displays a sharp turn. It corresponds with the area on the graph marked with a blue oval. After the reversal, there is an intensive downward movement showing a potential sell signal, offering to the trader the chance to understand how spread bets.

Bull & Bear Divergences

When applying the stochastic oscillator on a chart, divergence occurs rarely, but its signals are highly accurate.

For instance,

• Bearish divergence: When a price tend hits maximums, but the stochastic lines of %K and %D can’t overcome the previously highest prices(marked with the blue line) on the overbought or oversold region, it means there will likely be a reversal in the downward direction soon and works as a sell signal. Thus, we can open a short position after the indicator’s moving averages cross and the signal candlestick closes. In that situation a bearish divergence occurs.

• When the market price falls, but %К and %D curves don’t reach previous lowest prices (marked with red lines), it’s a sign of the upward reversal. We can open a buy trade after the cross and closure of the signal candlestick.  When this phenomenon we say that a bullish divergence occurs.

A rough change that occurs either on the overbought or oversold levels is known as stochastic divergence. Entry signals are marked with black circles.

Based on the text above, you can recognize the bearish divergence from a bullish divergence, in the overbought or oversold region. If you aren’t sure yet, you should read the article “What the divergence on Forex is” where the issue is explained in detail.

Ignore the fact that there is a different indicator in the article. The stochastic oscillator follows the classic rules of the technical analysis for bullish and bearish divergence and convergence. Everything you read in this article will work for the stochastic in order to monitor efficiently the price movement of our asset as well as to have a better understanding of when a bullish or bearish divergence occurs.

Bull & Bear Set-ups

Bullish and bearish patterns look the same as the stochastic divergences we covered above, but they provide different signals:

A bullish pattern is adjusted when the new highest price forms a lower-than-previous high, but the stochastic has a higher high than the last closing price. It leads to a short-term price trend decline and a reversal. So, this pattern should be used as a bullish entry point ahead of the upcoming rise.

A bearish pattern occurs when the new lowest price has higher lows, but the oscillator forms a lower minimum, indicating strong sell signals. Such types of price movement can be considered false signals since, later, the price will rebound and reverse.

Circles and violet lines mark local minimums on the price chart and the stochastic indicator. This means the formation of a bullish pattern that outruns the reversal signal. There is a short-term price decline (red area) where a trader can monitor how the spread bets, a price reversal, and a new bullish trend (green area).

Stochastic Oscillator: Best Trading Strategies and Real-Life Examples

Applying a trading strategy is essential for making a profit from trading on Forex. Even if you understand the price chart perfectly with the help of a stochastic oscillator, you may still suffer losses from Forex trading due to a wrongly chosen market entry point or a poor risk management and incorrect transaction volume. The given trading strategies with stochastic oscillators take into account all the intricacies that traders face in real trading.

The stochastic indicator allows you to receive many different signals. It can be used in different types of trading such as scalping, day trading, and swing trading. Read on to find out about the peculiarities of using the stochastic oscillator on different time frames.

Scalping

Scalping is a type of high-frequency trading. It is popular among algorithmic traders who use trading bots. 

This strategy is usually used with lower time frames from M5 to tick charts.

Scalping is similar to the stochastic crossing strategy. The only differences are the time frame and the setting of parameters that make the indicator more sensitive and faster.

Let’s use an M5 time frame and the following stochastic parameters to implement the scalping strategy:

• %K period 10;

• %D period 7;

• smoothing period 3.

Key levels to apply this strategy are 30 and 70.

We can open a long trade if the following conditions are met:

Conditions for opening a short position:

Stop Loss is placed at 3-5 previous candle’s swing low. Take Profit is set at the same distance between your entry point and Stop Loss or exceeds this distance by 5-10 points. It is recommended to trade with small fixed lots.

Examples of Long/Short Trades

You can enter into short trades when the indicator is in the overbought zone and the main line crosses the signal line from above. The right signal is marked with a blue circle on the indicator’s chart. Open a short position after the red candle closes (blue horizontal line). Place your Stop Loss just above the next swing high (red horizontal line). You can take profits upon receiving a reversal signal when the blue main line %K crosses the red signal line %D from below in the oversold zone (green circle).

When the indicator’s main line crosses the signal line in the zone below 30, you can enter into long trades. On the indicator’s chart, the buy signal is marked with a blue circle. The market entry point is marked with a blue horizontal line. Stop Loss should be set near the previous low (red horizontal line). You can close the trade and take profits after the stochastic oscillator generates a reversal signal (green circle).

Day trading strategy

Day trading assumes opening and closing trades within one trading day. It is better to use H1 or lower time frames. For example, you can pick M30. For this time frame, use a sensitive stochastic indicator with settings 5.3.3 and a slower one with settings 21.7.7 to identify the general trend.

Firstly, use a slow stochastic oscillator to identify the general trend. If the main line %K moves below from the upper area, the trend is bearish. On the contrary, if it moves from the below to the top, the trend is bullish. Depending on which zone the line is moving in, you can understand the life cycle of the trend. For example, if the line is starting to decline in the upper area of the indicator’s chart, it means that a bearish trend is emerging.

Market entry rules:

• open trades according to the trend’s direction, identified by the slow indicator;

• open short trades when the fast stochastic is located in the overbought zone and the main line %K crosses the signal line %D from above. Enter into long trades when the fast indicator is found in the oversold zone and the main line %K crosses the signal line %D from below.

Market exit rules:

• set Stop Loss below a swing low for a long trade or above a swing high for a short trade, considering the previous 3 or 4 candles;

• while the price moves in a favorable direction, replace your Stop Loss to a breakeven point;

• lock in the profit when the opposite signal to the one we entered the market with appears. For example, if a long trade was opened, the signal to close it will be the crossing of the indicator lines in the overbought zone.

Examples of Long/Short Trades

On the chart, let’s use the slow stochastic oscillator to determine the general direction. The indicator is moving up toward the overbought zone. Therefore, the trend is bullish.

When the indicator forms a golden cross in the oversold zone, this is a perfect time to open a long trade (blue circle). Enter the market in the area of the blue horizontal line and set Stop Loss just below the low. Close your position once you get a reversal signal (green circle).

Now, let’s see what happens when it comes to short trades.

The chart shows a bearish trend confirmed by the stochastic oscillator tuned to the mid-range 21.7.7 setting.

Within this trend, when the indicator lines cross in the overbought zone, open a short trade with Stop Loss just above the previous high. There is also a false crossover. Since an intersection of the lines occurs on the border of the oversold zone, not inside it, we can ignore this false crossover. The closing signal appears in the area of the green circle. Take profit on the close of the corresponding candle.

50-level crossing strategy

This strategy implies that a trader ignores the 20 and 80 levels. Instead, they only pay attention to the 50 level. Let’s readjust the stochastic oscillator to make it visually easier to apply this trading strategy.

This strategy requires one line, so if there is an opportunity to turn off the moving average %D, it is better to do it so that it does not hamper the overall picture. In addition, we mark the 50 level instead of levels 20 and 80.

The image above shows a readjusted stochastic oscillator.

How to trade using this strategy:

• enter the market when the buy/sell pressure causes the indicator to break through the 50 level. Open a long trade when the stochastic oscillator line crosses the 50 level from below. A breakthrough of the 50 level from above allows you to open short trades;

• place Stop Loss orders according to the standard rule just below the nearest swing low or above the swing high;

• exit from the market when the trend loses its strength, the indicator chart reverses and crosses the 50-level threshold in the opposite direction;

• this trading strategy is versatile and can be applied to any time frame and trading style.

On the GPBUSD chart, an emerging bullish trend drives the indicator to break the 50 level from below (blue circle). As soon as it generates a signal, open a long trade at the level of the blue line. Stop Loss is marked by the red line. The subsequent short-term pullback returns the indicator to the 50 level. However, there is no inverse crossover and we keep the trade open.

A little later, the indicator line breaks through the 50 level (green circle). At this point, the price has already risen significantly and we can take profits at the level of the green line.

Swing Trading

The strategy’s name best describes the principle of swing trading. According to this strategy, traders must first determine the long-term trend. Swing traders always follow the main trend but do not trade the trend itself but the waves within it.

To understand the stochastic swing strategy, we should learn the star pattern. There are two types.

The morning star consists of three consecutive bars:

• The first one is bearish with a long body;

• The second one forms with a gap (ideally) with a bottom shadow and a short body;

• The third one is bullish, with a long green body that overcomes the most significant part of the first candle’s body.

The opposite is the evening star. It includes three bars:

• The first one is bullish with a long green body;

• The second one has a short body and a gap up (ideally);

• The third one is bearish, with a long red body covering the most significant part of the first candlestick.

Conditions for opening a long position:

• Stochastic is below the 20 level;

• There is a morning star pattern at the reversal;

• The market starts moving upward.

Conditions for opening a short position by a swing trader:

• Stochastic is above the 80 level;

• There is an evening star pattern at a reversal;

• The market starts moving down.

We should open a trade as soon as the bar after the pattern crosses its extreme in the trend direction. The stop-loss is set at the maximum point of the star. We will close the position as soon as there is a cross of stochastic lines, either above 80% or below 20%.

To improve the accuracy of signals, you can also use additional indicators. For example, RSI, which is not as fast as the stochastic oscillator, but provides fewer false signals.

Examples of Long/Short Trades

Let’s consider a long and short setup in the market using a real example of swing trading.

The chart depicts the formation of an evening star pattern with simultaneous crossing of the indicator lines in the overbought zone (blue circle) for the fast stochastic 5.3.3. These are ideal conditions for a short setup.

We opened a trade at 1.37637, when the bar crossed the pattern’s minimum point (the blue line). A signal to exit the market was a curve cross marked with the red circle. We fixed the profit at 1.34695, the close of the candlestick. The final profit was 2942 points (1.37637 – 1.34695 = .02942).

Let’s consider a long setup using the example of a positional trade on the EURUSD daily timeframe using stochastic with settings 21.3.3. The chart above shows a golden cross in the oversold zone of the indicator, which is confirmed by the morning star pattern. At the level of its formation, enter purchases with a stop below the swing low. Take profit when a death cross forms in the overbought zone.

Using a Stochastic Oscillator When Trading S&P 500 and U.S. Dollar

Each instrument shows its own behavior. It’s crucial to consider it when trading. Below, we’ll look at stochastic trading features on the S&P 500 futures, gold, and the U.S. dollar.

S&P 500 Trading

Looking at this instrument’s historical price movements, it’s visible that the price decline doesn’t always follow a stochastic move to the overbought area. Vice versa, when the indicator is in the oversold zone, it’s more likely the market will rise soon.

The signals of a bullish reversal work well when the market is temporarily oversold in the uptrend. Signs of a bullish correction will likely work if the market entered an overbought area in the downtrend.

Gold Trading

When trading gold, it’s not recommended to use overbought/oversold signals even with a line crossing.

When the market is temporarily oversold in the uptrend, signals on a bullish reversal usually don’t work. Meanwhile, it’s likely a bearish reversal works when the market is temporarily overbought in a downtrend.

U.S. Dollar Trading

The U.S. dollar often continues moving following the momentum when curves enter overbought or oversold zones. Therefore, you should enter the market when there is a price reversal. The stochastic Forex strategy isn’t useful for USD if it’s based on fixing overbought conditions during an uptrend and oversold ones during a downtrend.

Combining a Stochastic Oscillator With Other Indicators

The stochastic oscillator is a high-frequency indicator that can generate false signals, especially in strong directional movements. It makes sense to use the oscillator with other trend indicators. Let’s consider the most popular combinations using any type of stochastic oscillator with other tools, such as the stochastic RSI.

Moving Averages

This is one of the simplest trend strategies that allow traders to get good results. To define a long-term trend, we will use the daily timeframe, while entry and exit points will be determined on the hourly one.

First, we add three exponential moving averages with periods of 50-, 100-, and 200-bars.

We use a stochastic oscillator to find the entry levels. The recommended settings are:

• Periods: 14, 3, and 3;
• Levels: 90% and 10%.

Conditions for a long trade:

• There is a long-term upward trend on the daily chart; the price moves up and is above the EMA (50), while the EMA (50) is above EMA (100), which, in turn, is above EMA (200).
• On the hourly chart, the oscillator crosses 10%.

Conditions for a short trade:

• There is a long-term downward trend on the daily chart; the price moves down and is below the EMA (50), while the EMA (50) is below EMA (100). And EMA (100) is below EMA (200).
• On the hourly chart, the oscillator crosses 90%.

Place the stop-loss slightly below the local extreme. Profit can be fixed by a take profit that is two times bigger than the stop-loss or by a trailing stop of EMA (50). If the most recent closing price is below it, you should fix profit.

In another version of the stochastic strategy on Forex, you should wait for the stochastic to enter overbought or oversold areas to fix profit. To make it clear, look at the example below.

We observe a long-term uptrend on the daily chart. Therefore, we will only open long trades while we monitor the most recent closing price.

With the hourly time frame, we wait until the curves cross 10% (the blue circle).

We enter the market at the close of the breakout bar where the lowest price is located (the blue line). A stop-loss is placed slightly below the minimum (the red line).

During the price movement, the stop-loss first moves to the breakeven and then to the profitable zone. We close the trade when the stochastic indicator comes closer to the 90% line where we compare it with the most recent closing price(the green line).

Trendlines

All trend strategies are used to open positions in the current trend or fix profit when the trend changes. Still, an entry point is considered a weak spot. A stochastic oscillator can solve this issue. A combination of a stochastic oscillator with any trend indicator can provide good results and avoid false signals.

In this regard, it’s essential to follow several rules:

1. Determine a trend on high timeframes;
2. Don’t open trades against the trend;
3. Use a %K and %D cross in the overbought/oversold areas to define an entry point.

Try to use a stochastic oscillator with your favorite trend indicator. Follow these three simple rules, and you will be surprised by the result.

Bollinger Bands

The Bollinger Bands indicator is the leading tool in this strategy, while the stochastic oscillator will be used as a signal filter. You can read more about them in my article “Bollinger Bands Indicator in Forex”.

Note! This strategy is intra-channel. The trade occurs within Bollinger Bands. The indicator settings are standard: the moving average period is 20 candles, and the standard deviation multiplier is 2.

We should also add a stochastic oscillator with 5, 3, and 3 parameters.

Conditions for a buy trade:

• A bar crosses (or at least touches) the bottom line of the Bollinger Bands;
• The %K line crosses the %D line bottom-up below 20%.

We can enter the market at the opening of the next candle after the signaling one.

Conditions for a sell trade:

• A bar crosses or at least touches the upper boundary of the Bollinger Bands;
• The %K line crosses the %D line upside-down above 80%.

Enter the market at an opening of the candle that follows the signal one.

A stop-loss is set with a small shift from the extreme point of the breakout bar. The ideal take profit level is at the opposite band of the Bollinger indicator. When working with a buy trade, it should be placed at the upper boundary, during a sell trade – at the bottom band.

Let’s take a look at the strategy of Bollinger bands and stochastic oscillators through an example.

The blue circle points to the moment when the bar touches the bottom line. In the same area, the %K crosses %D from the bottom, thus, confirming the primary signal.

We enter the market at the opening of the next candle (the blue line) at 1.17444. The stop-loss is set slightly below the minimum of the touch candle, and the take profit is at the upper boundary – 1.17808.

In a while, the price declines, almost touching the stop-loss level, but it turns around and surges. The trade is closed at the take profit level (the red circle). The final profit is 364 points (1.17808 – 1.17444 = .00364).

Pros & Cons of the Stochastic Indicator

Like any tool in technical analysis, the stochastic oscillator has several advantages and disadvantages.

Benefits	Limitations
Numerous signals: overbought/oversold, divergence, crossing of moving averages, crossing of level 50.	High accuracy can only be achieved when combined with other technical analysis tools.
Useful in any timeframe and market.	The effectiveness of the indicator largely depends on its correct settings.
Available by default in almost all trading and analytical platforms.	Fake signals, especially if the settings do not match the timeframe or market.
The stochastic oscillator indicator can be easily combined with other technical analysis tools and can be used in any trading strategy.	The indicator follows the price and, therefore, may lag. Signals can appear after the price movement has already begun.
	Stochastic does not consider the fundamental analysis and its metrics.