Stochastic is an indicator developed by George C. Lane in the late 1950s. It is a momentum indicator that measures the relationship between the currency’s closing price and its price range over a period of time you choose. The stochastic indicator doesn’t follow the price and volume but follows the momentum and speed of the price. This indicator helps in identifying the overbought/oversold conditions in the market, and traders use them to generate buy and sell signals. The stochastic indicator changes the direction before the price does, and that makes it a leading indicator in the market. Bullish and Bearish divergence in this indicator helps the traders to identify the significant trend reversals in the market.
How to read the Stochastic Indicator
The Stochastic oscillates between the 0 to 100 range in the market, and any reading above 80 shows the overbought market conditions and any reading below 20 indicates the oversold market conditions. In a standard 14-period setting, if the reading of the currency pair is above 80, that means the pair is at the overbought area, and you can expect a reversal in the market. Likewise, if the reading of a currency pair is below 20, that means the currency pair is in the oversold area.
Remember to use this indicator carefully during the strong market. Because during this time, the indicator either remains in the oversold or overbought area. So it is recommended to pair the stochastic with the other indicators to get genuine and accurate signals in the market.
Stochastic Indicator Formula
%K = (Present Close – Lowest Low)/(Highest High – Lowest Low) * 100
%D = 3 day Simple Moving Average of %K
Lowest Low is the lowest low for the look-back period
Highest High is the highest high for the look-back period
The default time period setting for the Stochastic Indicator is ’14’ irrespective of the time frame. It can be an hourly chart, daily, weekly, monthly, or an intraday timeframe. A 14-period %K would use the ‘most recent close,’ the ‘highest high over the last 14 periods’ and the ‘lowest low over the last 14 periods’. %D is the 3-day simple moving average of the %K. This %D line is plotted along with the %K line in order to act as a signal line.
Installing ‘Stochastic Indicator’ in MT4 (step – by – step process)
Stochastic is a popular leading indicator in the market, and it is available on the MT4 terminal by default. You can easily apply this indicator to your chart by following the below steps.
Open the MT4 terminal and click on Insert > Oscillator > Stochastic
A window will pop-up where you can change the settings according to your preference
As you can see in the image below, we have applied the stochastic indicator to a 60-minute EURUSD chart.
Trading strategies using the Stochastic Indicator
As we already know that the stochastic is a leading indicator. Most of the traders use this indicator alone to trade the market. But if you can pair this indicator with some other indicators, that will give you a stronger edge in the market. Below are some of the strategies.
Stochastic + Moving Averages
In this strategy, we pair the Stochastic with the simple moving averages to trade the GBPUSD currency pair. We are using the 9 and 5-period moving averages and the Stochastic indicator with default settings.
To generate trading signals using this combination, two things should happen
• The stochastic indicator should reach the overbought/oversold area and should give a sharp reversal
• The 9-period moving average should cross the 5-period moving average
We recommend you to use this strategy only when the market is trending as moving averages work the best only in trending markets.
As you can see in the below chart, GBPUSD was in pullback mode. Take a look at the circles we have marked. When the moving averages crossover happened, Stochastic gave the sharp reversal. This is a strong sell signal. If you had taken the ‘sell’ when this strategy gave us the first signal, you would have made 40 pips in the market.
If you had taken the ‘sell’ when this strategy gave us the second signal, you would have made 50 pips in the market.
In a single day, GBPUSD generates two potential selling signals for us. This is a proven strategy used by traders to generate reliable signals.
In the below CHFJPY 15 M chart, this strategy gives us three buy signals. When the Stochastic reached the oversold area and gave a sharp reversal, the moving averages crossover happened. It is a potential buy signal for us.
Stochastic + RSI Strategy
In this strategy, we are pairing the Stochastic Indicator with Relative Strength Index. The signals are generated when both the pairs reach overbought/oversold conditions and give a sharp reversal. We will also combine the Stochastic with RSI divergence to generate potential trading signals.
In the below EURCHF 60 M chart, when both indicators reach the overbought area and gave a sharp reversal, it is a sell signal. You can close your trade when any of the indicators reach the oversold area.
In the below EURCAD 60 M chart, when both indicators reached the oversold area and gave a sharp reversal, it is a buy signal.
Stochastic and RSI divergence Strategy
Divergence is when the price goes in one way but the indicator in another. It’s a prior sign of trend reversal in the market.
In the below EURNZD 60 M chart, both of the indicators are having a hard time to go higher, and the price was also losing its momentum. This is an excellent indication of a trend reversal.
As mentioned earlier, the major limitation of this indicator is that it produces false signals in the strong trending market. Because in the strong trending markets, sometimes, prices rise or fall sharply and the Stochastic keeps moving at the overbought/oversold area. Thereby producing false signals. That’s the reason why we suggest you to use the Stochastic in conjunction with other reliable indicators to take your trading decisions.
The Bottom Line
Overbought and oversold are significant areas that traders use to get the trading signals from the market, and the Stochastic indicator helps us in identifying the same. Any reading above 80 is considered as overbought, and below 20 is considered as oversold. Again, solely depending on this indicator alone is dangerous. Try experimenting with the strategies mentioned above and let us you if they have worked for you in the comments below. Happy Trading.