What is Stochastic Oscillator?

Stochastic Oscillator is a popular momentum indicator, widely known by market participants for its invaluable representation of the overbought and oversold status of the market. This indicator was developed by a famous financial analyst, Dr. George Lane in the 1950s.

According to Dr. Lane, the stochastic oscillator is a combination of price cycles, Elliot Wave Theory, and Fibonacci retracements. Currently, there are many swing traders around the world who prefers to use stochastic oscillator as their first choice for identifying the tops and bottoms of the market momentum.

How to add Stochastic Oscillator to MT4 charts?

  • First, open your MT4 chart. Click on the ‘Insert’ menu. Select ‘Indicators’ and ‘Oscillator’ menu then click on ‘Stochastic Oscillator’:

  • Set up the values, colors, and levels if required otherwise leave the table as default and click ‘Ok’ button:

  • Once you’re done with the setup, Stochastic Oscillator will appear in your chart like the following image:

Interpretation of Stochastic Oscillator

Stochastic locates the area of the close relative to the high/low range over the selected number of periods. It is assumed that momentum changes direction before the price does.

Thus, Slow Stochastic plots bullish or bearish divergences with price movements as a warning of reversals. This indicator is also used to identify the bulls and bears or overbought and oversold conditions of the market.

Slow Stochastic right at 50 signals a neutral bias, above 50 means the close is in the upper half of the range with upward momentum, below 50 indicates down momentum where the close is in the lower half of the range.

When Slow Stochastic over 80, it indicates that price is near the high of the range of the selected period and the condition is overbought if the market is ranging. On the other hand, below 20 indicates the price is near the low of the range of the selected period and the condition is oversold if the market is ranging.

Divergences: Price makes a lower low but Slow Stochastic makes a higher low at the same time plots bullish divergence and a bearish divergence occurs when price makes a higher high but Slow Stochastic makes a lower high over the same period.

Uses of Stochastic Oscillator

Buy in bullish momentum:

  • Stochastic value rises above 50 level
  • %K remains above the Slow Stochastic

Stochastic value above 50 represents the bullish momentum of the market. %K holds above the Slow Stochastic adds an extra confirmation about the bullishness of the momentum. You may directly go for the buy entry once the conditions are met. Price breaks above its current range with Stochastic value above 50 represents buy opportunities with the bullish breakouts. Stochastic value reaches above 80 with %K below the Slow Stochastic means price reached its overbought condition and it is time to exit the buy entry.

Sell in bearish momentum:

  • Stochastic value moves below 50 level
  • %K goes below the Slow Stochastic

This is a 15-minute AUD/USD (Australian Dollar vs US Dollar) chart. Initially, the market was moving sideway as the price was roaming within a short range. Later, we found a bearish bar that closes below the current range of the price.

At the same time, Stochastic value drops below the 50 level and %K moves below the Slow Stochastic representing an ideal sell opportunity within the bearish momentum of the market. Once all the confirmation is met, we put a sell entry right below the low of the respective large bearish bar. Stochastic value reaches below 20 levels and %K moves above the Slow Stochastic means market reaches its oversold condition and it is time to close the sell entry.

Trading directly based on bullish/bearish momentum signals from Stochastic Oscillator represents short-term trading opportunities thus, suits best as scalping and intraday trading strategies.

Swing trading using Stochastic Oscillator:

Stochastic Oscillator signals the overbought/oversold conditions of the market and uses its crossover signal to identify potential swing high or low of the market. For swing trading, traders aim to buy from the swing low and sell from the swing high of the market.

Buying from the swing low of the market:

  • Stochastic moves below its 20 level
  • %K moves above %D and bounces upwards from the oversold area

Remember, Stochastic value moves down to its oversold level doesn’t confirm the current price level as the swing low of the market. You must wait until %K crosses above the %D and both of them bounce upwards from its 20 levels.

Selling from the swing high of the market:

  • Stochastic value rises above the 80 level
  • %K moves below %D and bounces downwards from the overbought area

Stochastic value above 80 represents the basic signal of the overbought condition of the market. In such conditions, the price level should only be considered as the current swing high of the market when %K crosses below %D and starts to fall from the oversold level of the Stochastic Oscillator.

Swing trading is tricky but it allows the trader to achieve better profit margins compared to the risk involved with each trade entry. Thus, as a swing trader, you should target at least 1:2 risk to reward ratio while trading based on Stochastic Oscillator signals.

Conclusion

Stochastic Oscillator is one of the simplest momentum indicators around the market. Its easy demonstration of the market status and simplicity of use offer a great advantage for the newbie swing traders. Moreover, mastering Stochastic rules are easy and traders with any level of experience can apply it for real trading purposes. As a global trading indicator, it can be applied to trade all kinds of financial instruments like currencies, CFDs, futures, and stocks.

Furthermore, this indicator suits with all sorts of timeframe charts within the MT4 trading platform. Stochastic Oscillator can also be added with other trading indicators or strategies as a momentum filter. Besides, you can also add some of the basic indicators with Stochastic like support/resistance levels, pivot levels, moving averages, trendlines for creating effective trading strategies and enhancing better trading performance at the same time.

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