The stochastic oscillator is a momentum indicator like the RSI and just like the RSI it helps identify overbought and oversold securities. It is used to identify when a trend has started to become exhausted and as a result where a reversal is about to occur. Unlike the RSI, which shows the ratio of the high and low closes in a set period, the stochastic indicator takes the range of high and low prices within a set period and shows as a percentage, where the current price falls within that range.
The stochastic consists of 2 lines; a fast line (%K) and a slow line (%D).
%K = ((current price – lowest price in range) / (highest price in range – lowest price in range))x 100
%D = 3 day SMA of %K
A typical range for %K is 14 periods
Stochastic Oversold /Overbought regions
At the simplest interpretation, the region above 80% on the stochastic chart suggests an overbought market and the region below 20% suggests and oversold market. As long as it is used with other analysis tools, this interpretation is all that is required of the stochastic.
Stochastic Crossovers and trend reversals
However, the simple explanation only holds true while the market is ranging and there are many more complex interpretations that are often necessary. For example when the market price is ranging within a set channel, when the price reaches the upper end of that channel, the stochastic would show near the top over the significant 80% mark indicating the price is about to move back down and you should sell. However if the market is experiencing a break out with a sustained uptrend then the stochastic will stay above the 80% mark since the price will continue to be at the top of the previous range. Therefore it is important to identify the bigger trend in action and trade in the direction of the trend and ignore the frequent overbought readings in an uptrend or oversold readings in a downtrend.
As a result the stochastic moving down from 80% or up from 20% are stronger indicators of a trend change than simply being in the oversold or overbought regions. Another indicator to look out for is a crossover of the %K and %D lines.
If we look at the last 30 days (July 2011) and line up the signals generated by the stochastic with the price action we can see the stochastic is a very useful tool if used correctly.
A: The stochastic slow line exits above the 20% region indicating a buy signal
B: or C: The stochastic drops below 80% . Possible exit points for uptrend and indication of new downtrend
D: and E: These are tricky. In hindsight, if you had entered and exited when the stochastic lines crossed you would have probably taken a little extra profit with a small buy trade but more likely if you had waited for the stochastic to cross the 20% mark and put in a buy order then you would have probably lost out. A not-so-nice reminder to never leverage too much (3-4 times your deposited amount at most) and have an appropriate risk strategy with stop losses in place.
F: The true end of the downtrend. Where you can collect over 600 pips profit and put in a buy order for the next trend
G: Then end of a neat uptrend and beginning of a new downtrend.
H: The end of a downtrend and beginning of a new uptrend.
I: or J: Take some more profits and put in a sell order for the next probably downtrend.
To add a stochastic indicator to your MT4 demo or live platform, click on Insert > Indicators > Oscillators > Stochastic. You can select the %K period as 14 as I have done as the 5 period %K may be a little too choppy. To download the MT4 demo platform and demo trading account, click here.