The Stochastic Oscillator is a momentum indicator, which shows the speed or momentum of price and the relative position of the latest close compared to the high-low range over the period of interest. Invented by George Lane the premise behind the indicator is that momentum changes direction before price, and that prices tend to close near the upper end of the trading range in up-trends and the lower end of the trading range in downtrends. As the trend nears completion there is a tendency for prices to begin to close towards the other end of the trading range signalling an exhaustion of the trend.
%K = (Current Close - Lowest Low)/(Highest High - Lowest Low) * 100
%D = 3-day SMA of %K
Slow %K = Fast %K smoothed with a 3-period SMA (i.e. %D above)
Slow %D = 3-period SMA of Slow %K
The Full Stochastic Oscillator is a fully customizable version of the Slow Stochastic Oscillator where users can set the look-back period (of %K), the number of periods to slow %K and the number of periods for the %D moving average.
Lowest Low = lowest low for the look-back period
Highest High = highest high for the look-back period
SMA= Simple Moving Average
%K is multiplied by 100 to move the decimal point two places
Trading with the Stochastic Oscillator
The Full Stochastic Oscillator can be altered to behave as a fast or slow stochastic by changing the %K smoothing period parameter (higher values increase smoothing/slow the indicator), which controls the internal smoothing of %K.
Settings for the oscillator will depend on personal preferences, trading style and the timeframe of interest. Shorter look-back periods (%K) will result in a more volatile oscillator with numerous overbought and oversold readings. A longer look-back period will result in smoother oscillator with fewer overbought and oversold readings.
The Stochastic Oscillator is bound between 0 and 100. The default overbought and oversold levels are set at 80 and 20 respectively.
Trending markets - In trending markets traders should only use the indicator to trade with the trend as extreme overbought and oversold levels can persist for lengthy periods during periods of extreme buying or selling pressure. Traders can look to go long when the %K or %D falls below the oversold line trailing a buy-stop above market. When the stop is executed a stop-loss should be placed below the low of the recent down-trend (lowest low since %K or %D breached the oversold boundary).
Conversely short positions can be initiated when the %K or %D rises above the overbought line by trailing a stop below market, placing stops on execution above the high of the recent up-trend. Trend indicators should be used to determine exit points.
Ranging markets - The oscillator is ideally most suited for trading ranges. The main trade signals listed in order of importance are:
*%K or %D interactions with the overbought/oversold levels; and
*%K crossing % D (signal line crossovers)
*Divergences of the %D with price should be watched closely. Traders should look to go long on a bullish divergence (on %D) especially where the first trough is below the oversold level.
The bullish divergence can be confirmed via a resistance break on the price chart, Stochastic Oscillator break above 20 or 50, or a signal line cross where the %K cross the %D.
Short positions are taken on a bearish divergence (on %D), especially where the first peak is above the overbought level, and confirmation by the price chart or stochastic oscillator is received (break below 80,50 or signal line cross).
Bull/Bear set-ups are also taken as buy/sell signals. A bull set-up occurs where the currency forms a lower high but the stochastic oscillator forms a higher high showing strengthening upside momentum. Conversely a bear set-up occurs where the currency forms a higher low but the stochastic oscillator forms a new lower low.
%K, %D interactions with the overbought/oversold boundaries should also be watched. Traders should look to go long when %K or %D falls below the oversold level and rises back above it, and go short then the %K or %D rises above the overbought level and then falls back below it.
%K crossings over %D should also be noted, traders may wish to go long when the %K crosses to above %D. Short positions are taken when %K crosses to below %D.