Trading is basically opening UP or DOWN orders. The crucial thing to be successful in trading is knowing when to enter the market. Here the signals come in hand. But are the signals always good? Not necessarily. Some of them may be false. This is why it is important to filter them and not to use too many in the chart.
The indicators that might help in this task are called oscillators. They measure the waves of the market. All markets are always moving. And these movements remind of the waves. Up and down, up and down. Even in the trending or ranging markets, it is possible to observe the waves. So the oscillators are presenting the waves of the market visually, making it easier for the traders to make a good decision about entering a position.
The Stochastic oscillator
One of the oscillators that can help in catching the wave is the Stochastic indicator. It is the oldest oscillator that has been developed. It measures momentum by comparing the last closing price with the previous high-low range within a given period.
The Stochastic is composed of two lines, one is called %K and the other one %D. They oscillate between 0 and 100 values. You will see two horizontal lines in the indicator’s window. They represent 20 and 80 values and indicate the oversold and overbought areas.
The indicator’s formula is pretty simple:
%K = [(Close – Low N) / (High N – Low N)] / 100,
%D = simple moving average of %K in 3 periods.
Close is the last closing price,
Low N is the lowest price measured during N periods,
High N is the highest price observed within N periods.
Every indicator comes with the default settings. For the Stochastic, these are %K – 14, %D – 3, m – 3 bars. A trader can, however, adjust them depending on individual needs. A trading strategy, a specific asset, or entry frequency matter when choosing the parameters.
The period of %K specifies the amount of the periods should be considered when calculating the blue line of the Stochastic. With a larger period, the line becomes smoother and the bounces are lower. Long-term traders choose trades like that. When the period is smaller, the bounces are more frequent and give more signals. This may be a good choice for short-term traders. Bear in mind, however, that the lower period produces some amount of false signals.
The period of %D specifies the number of periods that are utilized for the simple moving average of the %K. With a larger period, the peaks and bottoms become smaller. With a small period, the effect of the moving average can be too weak. This period most often is set between 3 and 9 bars.
Using the Stochastic at Olymp Trade
By observing the indicator’s lines a trader can predict a trend reversal. It happens when %K and %D cross each other in the oversold or overbought areas. It means the bears or bulls are losing their power and the opponents are overtaking control over the prices.
There are some disadvantages of using the Stochastic to predict a trend reversal. The signals may sometimes indicate a trend reversal that is not complete. To strengthen the signals you can use a trick of adding one more Stochastic to your chart.
Double Stochastic strategy on the Olymp Trade platform
In this strategy, you will be using two Stochastic oscillators. One is called fast and the other slow. The first one’s parameters should be set for 8, 5, and 3. And the parameters of the second one for 17, 7, and 3. This trick will help to increase the accuracy of the signals offering by the indicator.
The fast Stochastic shows preliminary trading signals. But you will not open a position based on these cues. Instead, you will monitor the indicators further and wait for a slow Stochastic to confirm the signal. Thanks to that you will not enter the market too soon.
Using the Double Stochastic strategy for long entries
The picture below presents the chart for a GBPUSD currency pair with 15-minute candlesticks. There is a signal of the trend reversal from the Fast Stochastic. Its lines intersect in the oversold area. You keep following the Stochastic and after a few candles you get the confirmation. The lines of a slow Stochastic cross each other in the oversold zone. Now is the time to enter the trade. With 15-minute period candles, you can hold a position open for an hour, which means 4 candles. If your chart is set for 5-minute candles your trade should last 15-20 minutes. And if you prefer longer periods like for example 1 hour, you can open a position for 4 hours.
Using the Double Stochastic strategy for short entries
In our example below for the EURUSD currency pair, you may observe two situations where our strategy gives the signals. Remember, first you are waiting for the fast Stochastic to cross over in the overbought zone. Then, for the slow Stochastic lines to intersect in the overbought area as well. And again, the length of the trade depends on the chart you are using. For 5-minute candles, you can open a position for a duration of 15-20 minutes, for 15-minute candles the trade can last 1 hour, and for a 1-hour chart, it can be as long as 4 hours.
Pros and Cons of Using Stochastic Oscillators in Trading📊
- Easy to Understand: Once you grasp the concept, using stochastic oscillators is relatively simple.
- Identification of Overbought and Oversold Conditions: This can help predict possible price reversals.
- Useful in both Trending and Range-Bound Markets: Oscillators can provide valuable signals in varying market conditions.
- Potential False Signals: Oscillators can occasionally provide misleading signals, particularly in highly volatile markets.
- Requires Complementary Tools: For better accuracy, stochastic oscillators are often used in conjunction with other indicators or chart patterns.
- Not Foolproof: While useful, no indicator can predict market movements with 100% certainty. Sound risk management is crucial.
Stochastic Oscillator Trading Elements 📉📈
|Oversold and Overbought Levels||The Stochastic oscillator helps identify overbought (>80) and oversold (<20) market conditions.|
|Signal Line (%D)||%D line (average of %K) is considered as the signal line. Crossovers with the %K line can generate trading signals.|
|Divergence||When price forms a new high/low but the Stochastic oscillator fails to do so, it’s a divergence and can indicate a potential trend reversal.|
|Double Stochastic Strategy||This strategy uses two Stochastic oscillators (fast and slow) to increase signal accuracy.|
The Stochastic is a very old and very popular oscillator. It shows oversold and overbought areas and thus giving the signals that the trend will reverse. It has some weaknesses though. That is why financial derivatives traders have invented a strategy based on not one, but two Stochastic indicators. It increases the effectiveness of the signals so the probability of success is much higher.
With this knowledge, you should head for the Olymp Trade demo account and check how this strategy works. Share your experience with us in the comments section down below.
Wish you good luck!
Quick Q&A Section🔍
- Q: What does the Stochastic oscillator measure?
A: The Stochastic oscillator measures the momentum of price changes in the market by comparing the last closing price with a recent high-low range.
- Q: Can the Stochastic oscillator be used alone for making trading decisions?
A: While it can provide valuable signals, using it in isolation may lead to false signals. It’s often used in conjunction with other indicators or trading strategies for better accuracy.
- Q: What is the Double Stochastic strategy?
A: This strategy uses two Stochastic oscillators with different settings (fast and slow) to improve the accuracy of the trading signals.
- Q: How are overbought and oversold levels indicated in the Stochastic oscillator?
A: Generally, a value above 80 indicates an overbought condition (potential for price decrease), while a value below 20 indicates an oversold condition (potential for price increase).
- Q: What is a divergence in the context of the Stochastic oscillator?
A: Divergence occurs when the price forms a new high or low, but the Stochastic oscillator does not. This might signal a potential price reversal.
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