Stochastic oscillator – is a technical indicator designed by the president of "Investment Educators" Co George C. Lane in the end of 1950-s. Stochastic estimates market momentum and shows position of present price against price range (between High and Low) for a definite time period. It is measured in per cent from 0 to 100.
According to George C. Lane, “doesn't follow price, it doesn't follow volume or anything like that. It follows the speed or the momentum of price. As a rule, the momentum changes direction before price .”
Having opened settings of the indicator in MetaTrader 4 trading terminal, we will see the following preferences:
Let's figure out in responsibility area of each parameter and what measurement formula of the indicator is:
Period%K – the number of time periods used in calculation;
Slowdown %К – is the values used for internal smoothing of line %К (the higher value is, the slower oscillator gets);
Period %D – the number of time periods used in calculation of moving median line %К;
МА method – method smoothing over moving average in calculation of %D (simple, exponential, smoothed and weighted)
Formula for calculation of values:
Close - Close price of current period;
Min(Low(%K)) - the least Low for a definite number of periods %K;
Max(High(%K) -The biggest High for a definite number of periods;
MA – moving average;
N – smoothing period;
Looking at formulas, we still have incomplete understanding of what is showed by the indicator. To put everything right, we will give an example:
We want to calculate value of %K for the last 7 days. Over this period, the price had reached Low as of 1,33530 and High as of 1,37102, Close of previous period is 1,34538.
It means that present Close price is on the level of 28,25 % from the last seven days' range. If we get result %K=0, that would mean that price has its High for chosen period, if %K=100, it means that price has the Highest value for entire period.
How can we benefit from that?
Lane pointed two important areas: (0-20) – oversold zone, (80-100) – overbought zone. This way, if the price is above 20, price is considered rather underestimated and if it is above 80 – it is overestimated a lot. But we should remember that Stochastic Oscillator operates the best if there is no trend on market. This is a crucial point, where many beginning traders lose their money. Under trend, position of Stochastic (%K or %D) above 80 is not a reason for sale, price can grow further and if Stochastic is below 20, price can drop further.
Which trading signals are shown by the indicator after all?
1. Crossing of %K and %D lines.
Signal for sale: %K line crosses %D from bottom to top.
Signal for purchase: %K line crosses %D from top to bottom.
2. Leaving oversold/overbought zone.
Signal for purchase: Stochastic enters zone (0-20) and then gets above 20.
Signal for sale: Stochastic enters zone (80-100) and then gets below 80.
To reduce false signals, very often two above-mentioned signals for entrance are combined.
An example of trading signals conveyed by Stochastic with preferences (5,3,3) for the first and second methods:
3. Divergence is the split up between indicator's direction and price chart.
There is bullish ans bearish divergence of Stochastic Oscillator. Bullish divergence is formed, when price chart reaches a new Low, Stochastic is in oversold zone (0-20) and cannot reach a new Low. Bearish divergence is formed, when price accomplishes a new High, Stochastic is in overbought zone (80-100) and cannot confirm a new High.
In conclusion we can tell that the indicator is rather interesting and its main disadvantage is an immediate response to change of price and plenty of false signals against major movement in the result. But if to define market trend beforehand, Stochastic can be useful on short-term rolls back to enter market towards trend. Also oscillator is often used as filter for other indicators and vice-versa. Anyway, you can try out settings of the indicator: make it quicker or slower, you can define other borders of overbought/oversold depending on market phase – trend or flat.
* Stochastic Oscillator "doesn't follow price, it doesn't follow volume or anything like that. It follows the speed or the momentum of price. As a rule, the momentum changes direction before price