Stochastic Oscillator is a tool used by many investors in technical analysis on the Forex market. Let’s explore with Forex Trading the concept what is stochastic to achieve better trading performance.
what is a stochastic indicator?
Perhaps the concept of what is stochastic is still unfamiliar to newbies. Stochastic Oscillator is a popular momentum indicator in technical analysis. Stochastic can customize limit levels and configurations according to needs. But it is possible to create false signals in narrow fluctuating markets. Even so, the concept what is stochastic is still a useful tool for technical traders.
what is the stochastic indicator?
Stochastic Oscillator, often abbreviated as Stochastic or Stoch. It measures the correlation between the closing price and the price range of an asset. Everything is within the specified time period. The concept what is stochastic was born in the late 1950s by Dr. George C. Lane. It then became one of the widely used tools.
The concept of what is stochastic is considered a versatile tool that can be applied in the following areas:
- Divergence detection
- Intraday trading
- Scalping
- Identify Buy/Sell signals
- Confirm overbought/oversold condition
- Daily Swing (medium-term trading, combining technical and fundamental analysis) with Admiral Pivot.
indicator of what is stochastic. The concept of what is stochastic indicates the ability to measure market momentum. That is the rate of change of price compared to the expected or actual price. The Stochastic Oscillator can give signals about what is pricing strategy right before it actually happens.
what is stochastic belongs to the group of indicators that measure momentum? It is used to compare the closing price of a stock with the price range over a specified period. This is a type of oscillation that is limited in range and activity. All are between 0 and 100 according to standard settings.
- When prices are rising, closing prices move toward the upper boundary of a price range.
- When prices decline, the closing price usually approaches the lower boundary of a price range.
See more: Learn Dow theory for trading beginners
Meaning of technical analysis of the Stochastic indicator
As for the concept what is stochastic, being above the 80 level shows that the market is in an overbought condition. In this case, a sell order should only be issued when Stochastic begins to reverse. That is when the %K line crosses below the %D line in the range above 80. The intersection of these two lines is often a sign that the market is turning to selling.
Conversely, when the momentum indicator is below level 20, this shows that the market is in an oversold state. You should only open a buy order when what is stochastic starts to reverse. That is when the %K line crosses above the %D line in the range below 20. The intersection of these two lines is often a sign that the market may shift to a buying trend.
- Identify buy/sell signals. (When %K and %D cross down from levels above 80, this is a sell signal. When %K and %D cross up from levels below 20, this is a buy sign).
- Identify Bullish Divergence and Bearish Divergence
The concept of what is stochastic also shows that it is a trailing indicator. Therefore, it only works effectively when the market has no clear trend. When the market fluctuates in a narrow range, this indicator is often ineffective. Because the %K and %D lines will cross many times, leading to unclear signals.
When performing analysis, you do not need to limit yourself to the range 20-80. Which you can customize to 75-25, 70-30, or 85-15. For the futures market, the default setting of 5-5-5 is usually kept. While with the spot market, you can use a 5-3-3 configuration.
Structure of Stochastic
The concept what is stochastic and includes two oscillating lines, which are %K and %D.
The %K line (usually blue) is the main oscillator line. It was coincidentally named by Lane because it was relatively close to the price range under consideration.
The %D line (orange) is a simple moving average (SMA). It is calculated based on the value of the %K line over a period of three sessions. For that reason, the %D line often has a noticeable delay compared to the %K line.
Limit levels: Normally, the lower limit is 20 and the upper limit is 80. But you can customize it to 75-25, 70-30, or 85-15. When the price crosses the 80 level, this shows that the market is in an overbought state. Conversely, when the price falls below 20, the market is falling into an oversold state.
Normally, the %K line reflects actual price movements. The %D line is a simple moving average (SMA) calculated from the data of the %K line. Traders often use the interaction between the fast line (%K). And a slow-moving average (%D) to identify overbought or oversold areas. From there, determine the time to enter or exit the market.
Stochastic calculation formula
The method of calculating the indicator what is stochastic is done according to the formula below:
%K = [(C – L14) / (H14 – L14)] x 100%
The calculation formula is as follows:
- C is the closing price at the current time.
- L14 is the lowest price in the past 14 trading sessions.
- H14 is the highest price in the last 14 trading sessions.
- %K is a Stochastic value that reflects the recent market situation, mainly for currency pairs.
- %D is the 3-period moving average (SMA) of %K. Also known as “Slow Stochastic”. Because it reacts slower than %K when there are price fluctuations in the market.
The timeline mentioned above is standard. But you can customize it to the time frame that suits your trading goals.
How to install the indicator What is stochastic
The concept of what is stochastic is also available on trading platforms. How to install as follows:
- Step 1: Register an account on MT4 and log in to the system.
- Step 2: In the toolbar, select “Insert” >>> Indicators >>> Oscillators >>> Stochastic Oscillator.
- Step 3: Set options in the sections: Parameters, Scale, Levels, and Visualization.
In the Parameters section, you can set the period for the %K, %D lines, and the Slowing coefficient. Also, choose the moving average type in Method. You can also adjust the thickness, thinness, and color of these indicator lines.
To adjust the upper and lower limits, you can set them in “Levels.”
If you want to customize the display time frame, adjust it in “Visualization.”
- Step 4: Complete the settings, and click OK to apply the Stochastic indicator to the price chart.
How to do forex technical analysis using the indicator what is stochastic
The concept of what is stochastic isused to determine overbought or oversold areas in trading. But relying only on this indicator can lead to inaccurate signals. Experts recommend that you learn more about the concept of what is hawkish and combine Stochastic with other tools. For example, RSI, moving average or price patterns. The purpose is to increase the reliability of trading signals.
Use the Stochastic RSI indicator in combination
Similar to the concept of what is stochastic, Stochastic RSI (StochRSI) is an indicator in technical analysis. It has a value between 0 and 1 (or between 0 and 100 on some charting platforms). This indicator is created using the Stochastic oscillator formula. They are above the set of relative strength index (RSI) values.
First, investors need to determine whether the current trend is up or down through a combination of analyzing support and resistance levels on higher time frames. The important rule is to buy when the market is rising and sell when the market is falling.
- Buy signal: Wait for the price to complete a corrective decline in an uptrend. When what is stochastic and RSI shows signs of recovery from the oversold area. This signals the possibility of continued upward momentum.
- Sell signal: When both Stochastic and RSI start to go down from the overbought zone. That shows the price tends to end its corrective rally amid a downtrend.
Use the Stochastic RSI indicator in combination
How to execute trading orders:
- Entry point: Set at the signal area. Use green candles for Buy orders and red candles for Sell orders.
- Stop loss: You can use the ATR indicator. The purpose is to determine the stop-loss level. Or place below the support zone for buy orders (Buy) and right above the resistance zone for sell orders (Sell).
- Take Profit Point: Set profit target based on desired R:R ratio. Or use key levels in the Fibonacci Extension tool.
The technical analysis combines trendline with what is stochastic
Combining the concept what is stochastic with trend lines is a method that helps increase the chance of success.
- Buy signal: When the trend is uptrend and the upward momentum is still strong. You can draw an upward trendline and wait for the price to return to test that trendline. At the same time, the Stochastic Oscillator needs to be in the oversold zone to confirm a buying opportunity.
- Sell signal: When the current trend is a downtrend and the downward momentum is still strong. Draw a downward trendline and wait for the price to adjust up to test that trendline. At the same time, the Stochastic Oscillator needs to be in the overbought zone to reinforce the sell signal.
Trading method:
- Entry point: Place an order at the bullish candle when the price touches the upward trendline. That’s for buy orders. For sell orders, enter the order at the bearish candlestick when the price touches the downward trendline.
- Stop-loss: For buy orders, set the stop loss point just below the trendline. For sell orders, place a stop loss above the trendline.
- Take profit: Take profit according to the trader’s desired R: R ratio. At the same time, it must match the important levels on the Fibonacci Extension.
Use a combination of Stochastic and price divergence
Buy signal
In a downtrend, when a bullish divergence signal appears between Stochastic and price. This means that the price creates a lower bottom than the previous bottom. But the Stochastic indicator creates a higher bottom than the previous bottom. This shows that there is a possibility that the price is about to reverse from decreasing to increasing. In this case, you should consider placing a Buy order with the following steps:
- Entry point: When there is a green candle confirming a price increase or at the intersection between %K and %D.
- Stop-loss: Set stop loss at the nearest bottom before a bullish divergence occurs.
- Take-profit: Take profit according to your expected R: R ratio.
Sell signal
In an uptrend, if there is a bearish divergence signal between the momentum indicator and the price. Or maybe the previous peak price is not equal to the next peak. But the Stochastic indicator creates the opposite. This signals that the upward momentum may be weakening and the price may reverse to decline. This is the right time to place a sell order in the direction of the forming downtrend.
- Entry point: At the red candle confirming price reduction or at the intersection of the %K and %D lines.
- Stop-loss: Set the stop-loss point at the nearest peak before a bearish divergence appears.
- Take-profit: Take profit according to your expected R: R ratio.
How to analyze Forex technical analysis combining Stochastic with candlestick reversal patterns
The conceptual method what is stochastic is an addition to the method mentioned earlier. If there is a divergence between Stochastic and price, there are also strong candlestick reversal patterns. Then the reversal signal will be more reliable.
- Buy signal: In a downtrend, if there is a bullish divergence signal between Stochastic and price. At the same time, bullish candlestick reversal patterns appear. For example, Hammer, Dragonfly Doji, Inverted Hammer, Bullish Engulfing, etc. This is a good sign of a possible reversal to an uptrend.
- Sell signal: If the market is in an uptrend. It also shows a bearish divergence signal between Stochastic and price. Along with the appearance of bearish reversal candlestick patterns. For example, Hanging Man, Gravestone Doji, Bearish Engulfing, Shooting Star… This is a sign that there is a possibility that the market will reverse and decrease. This is the right time to place a sell order.
The technical analysis combines Stochastic Oscillators with price patterns
This strategy is widely applicable and effective for both trend trading or reversal trading. However, when combining Stochastic with price models to trade reversals. Traders need to perform analysis on higher time frames to increase accuracy.
In the continuation model:
- Buy signal: When Stochastic enters the oversold zone (below level 20). Then the price model tends to continue to increase. Such as a rising wedge, rising pennant, or rising rectangle.
- Sell signal: When Stochastic enters the overbought zone (above level 80). Along with the appearance of the price model, the downward trend continues. Examples are bearish pennants, falling wedges, bearish triangles, bearish flags, or bearish rectangles.
The concept what is stochastic combined with the continuation price model In the price reversal model:
- Buy signal: When the Stochastic indicator shows a bullish divergence signal with the price line. At the same time, strong price reversal patterns appear. For example, inverted head and shoulders, double bottom or triple bottom patterns.
- Sell signal: When the Stochastic indicator creates a bearish divergence signal with the price line. At the same time, price reversal patterns appear such as positive head and shoulders, double tops, or triple tops.
See more: Optimize trading with IC Markets Exchange
How to do forex technical analysis combining Stochastic and moving averages
This is a comprehensive combination to identify trends and find entry points. Therefore, traders should add the EMA200 line to the chart.
At this time, the EMA acts as a hard resistance zone to help identify trend-following transactions. You can adjust the EMA cycle to suit your timeframe and trading strategy. You can also use a combination of EMA or SMA crossovers. The purpose is to both confirm the trend and look for trading signals.
- Buy signal: When Stochastic falls into the oversold zone and touches the EMA200 line, which is pointing up. This suggests that the price may be preparing to resume the main uptrend.
- Sell signal: When Stochastic moves to the overbought zone and touches the EMA200 dynamic resistance line. This signals that the price may be preparing to trend lower.
Conclude
Stochastic Oscillator is a powerful tool in technical analysis. It helps identify overbought and oversold zones as well as detect divergence signals. Stochastic’s versatility allows it to be applied in many trading strategies. That’s what Forex Trading wants to give you about what is stochastic
FAQ about what is stochastic
Is a Stochastic Oscillator suitable for all types of markets?
Stochastic works best in clearly trending markets. In markets that fluctuate strongly or fluctuate in a narrow range. Stochastic may not give accurate signals.
How should I set the Stochastic parameters to suit my trading style?
The standard timeline is usually 14 periods. But you can adjust the period and limit level according to your trading style. Some common configurations are 20-80, 25-75 or 30-70.
Can a Stochastic Oscillator be used for short-term trading?
Yes, Stochastic is widely used in short-term trading. Especially fast trading (scalping). But you need to pay attention to avoid false signals due to market fluctuations.
