The Stochastic Oscillator is one of the most widely used technical indicators among traders. Its primary function is to compare the current closing price of a trading instrument with prices over a specified time period. The Stochastic Oscillator features two lines: the main line (%K) and the signal line (%D). The %D line is a moving average of the %K line. Typically, %K is displayed as a solid line, while %D is shown as a dotted line. It is a standard indicator included in the MetaTrader trading platform.
How to Use the Stochastic Indicator
Analysts interpret the Stochastic Oscillator in several ways:
- The Stochastic indicator signals a buy when the oscillator (%K or %D) first falls below a certain level (commonly 20) and then rises above it. Conversely, it signals a sell when the indicator first rises above a certain level (commonly 80) and then falls below it.
- A buy signal occurs when the %K line crosses above the %D line, and a sell signal occurs when the %K line crosses below the %D line.
It is also important to watch for divergences: for example, when prices make new highs but the Stochastic Oscillator fails to reach higher peaks.
Stochastic Oscillator Calculation Formula
The calculation of the Stochastic Oscillator involves four variables:
- %K periods – the number of single periods used to calculate the indicator.
- %K slowing periods – the degree of internal smoothing applied to %K (a value of 1 produces a fast indicator, while 3 produces a slow one).
- %D periods – the number of single periods used to calculate the moving average of %K.
- %D method – the smoothing method (exponential, simple, smoothed, or weighted) used to calculate %D.
The formula for calculating %K is:
%K = (CLOSE – LOW(%K)) / (HIGH(%K) – LOW(%K)) * 100,
where:
- CLOSE is today’s closing price;
- LOW(%K) is the lowest low over the %K periods;
- HIGH(%K) is the highest high over the %K periods.
The formula for calculating the moving average %D is:
%D = SMA(%K, N),
where:
- N is the smoothing period;
- SMA is the simple moving average.
Using the Stochastic Indicator
The Stochastic Oscillator is commonly used in medium-term forex trading strategies alongside trend indicators to confirm signals, since oscillators can produce many false or short-term signals during sideways market conditions.
Additionally, oscillators may be unreliable during sharp increases in trading volume caused by important news or crisis events, so relying solely on the Stochastic Oscillator for trading can be very risky.
