The stochastic oscillator is a momentum indicator used in the technical analysis that follows the speed of price. It follows the momentum of price and does not follow the price itself or the volume of the price.
Stochastic trading follows the resistance and support concept that the prices of securities — either upwards or downwards — tend to stop and reverse at some point in time having regard to the level of prices. Most traders normally apply the stochastic trading strategy as a means of spotting overbuy and oversell points in the marketplace.
The term “stochastic” means the location or level of a current price as compared to its range over a defined period of time.
Video: Using the Stochastic Indicator
There are generally three different kinds of stochastic oscillators that are used by traders. They are fast, slow and full stochastic oscillators. Each of them functions in an analogous manner.
Whenever traders make reference to trading with stochastic oscillator, they are simply making reference to the slow stochastic, which will be the main focal point of this article.
How to Trade with the Stochastic Oscillator Indicator
The fundamental principle of stochastic trading is that prices have a tendency to close at the top most end of their trading series in an upward trend, and at the lower end of the trading series in a downward trend.
Whenever prices tend to close on the topmost end of their series in an uptrend, it could be a signal that the impetus of the trend is burly and the same is an inverse for a downtrend.
The stochastic oscillator is made up of two lines that are drawn in the price chart and are referred to as the %K and %D lines respectively. In the same way as the RSI, the stochastic is a lined oscillator such that the %K, as well as %D lines, oscillate between the 0 and the 100 mark.
The lines are normally drawn at the twentieth and the eightieth which indicates the high and the low ends of the series.
George C. Lane, who developed the stochastic oscillator in the 1950’s, used the stochastic oscillator which is range bound to predict future reversal and spot the bull and bear setups.
Since momentum changes direction first before price does so, the bull and bear divergences can be used to forecast reversals in the same. It measures the level of the closing price relative to the highest and lowest range of prices over a defined period of time.
How to Calculate the Stochastic Oscillator
The stochastic oscillator is calculated as:
%K=100 Closing Price – L, H – L
H= Lowest prices over a period of time
L= Highest price over a period of time
%D = 3 periods moving average of %K.
No matter what charting system you decide to apply, it will automatically work out the bands for you. However, it is important to note that the data points which make up the %K are normally an indication of where the marketplace has stopped every time in regards to the trading series for the fourteen intervals applied in the indicator.
In a layman’s term, the %K in the stochastic oscillators is simply a measurement of the drive that the marketplace has.
The %D band is simply a five interval easy moving mean of the %K band. In the end, you ought to know that you can alter the inputs that the indicator uses and apply, for instance, a three phase moving mean of the %K band to obtain a quicker signal.
This is basically a prelude to the different types of stochastic oscillators, and the fact that a number of traders in the Forex market place are not aware of how to go about altering the inputs, it is not recommended to alter the inputs when trading with a stochastic oscillator.