The Stochastic oscillator is a traditional technical indicator developed by George Lane in the 1950s. It is one of the few indicators that are based on price-action and Support and Resistance. In this article you will learn how it is calculated and how to implement it in your trading.
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Calculation and Formula
Stochastic %K = 100 X (Close - Lowest Low) / (Highest High - Lowest Low)
Stochastic plots the position of price in relation to its low and high from several last bars - that is, its support and resistance levels. So the Lowest Close and the Highest Close of the price in last 10 bars is calculated, and the location of price in relation to these levels is calculated - as a number between 0 to 100.
Stochastic is usually smoothed (or slowed) using a Moving Average. The result of the smoothing is known as the Stochasic %D.
This calculation makes the indicator sensitive to Support and Resistance levels which are the heart of price action and reversal. Low values indicate that price is near a Support level, and high values indicate that price is near Resistance level. However, the Stochastic Oscillator does not verify that the level is indeed a strong psychological level, but merely checks for local minimum\maximum. In order to increase probability of signals, one must check for Support and Resistance strength manually.
The premise behind the indicator is that above 80 the price is overbought, and below 20 the price is oversold. The assumption is that the level of 0 and 100 are the past Support and Resistance, and therefore price will stop at these levels and reverse.
Long Signal - When price crosses 20 level from below.
Short Signal - When price crosses 80 level from above.
This indicator is a Range indicator, that works best in periods of minimal trend. In period of trend this indicator usually gives false signals, because the Highest close or Lowest close are NOT Support nor Resistance. This is why this indicator is usually more powerful when combined with a Range filter, such as a Moving Average Slope indicator.
Another interpretation is using the %D and %K crosses. %D is the Smoothed version of the %K line, and trading signals are generated in the following way:
Long Signal - When Stochastic %K crosses %D from below.
Short Signal - When Stochastic %K crosses %D from above.
Another method of trading with the Stochastic Oscillator is using a Trend-Following approach. This method has first been described in Jake Bernstein's Book: The Compleat Day Trader. The method's basis is the following:
Long Signal - When price crosses 80 level from below.
Short Signal - When price crosses 20 level from above.
Exit Signal - When Stochastic %D crosses %K in direction reversed to open trade.
Researches show that in Forex the best trading results are yielded when using a 60-40 levels in the Trend-Following system, that is: Long signals are from level 60 and above, and Short is level 40 and below. This allows traders to enter trades earlier in the development of trend, and take larger profits.
In conclusion, the Stochastic indicator is a very good in ranging period, and weaker in trending phases. Be sure to confirm its signals with the proper market phase, for maximum profitability.
This article is intended solely for information purposes. The opinions are those of the author only. Please conduct further research and consult your financial advisor before making any investment/trading decision. No responsibility can be accepted for losses that may result as a consequence of trading on the basis of this analysis.
Information, charts or examples contained in this lesson are for illustration and educational purposes only. It should not be considered as advice or a recommendation to buy or sell any security or financial instrument. We do not and cannot offer investment advice. For further information please read our .