However, most traders calculate the Stochastic Oscillator based on 14 periods, which can be 14 days on a daily chart or 14 hours on an hourly chart for example. It is recommended that you double check the stochastic oscillator settings on your favorite charting platform to confirm the number of periods it is using. Keep in mind that the volatility of different Forex pairs will vary. As the volatility varies based on which currency pair you are trading, you can try to tweak the period settings to improve the efficiency of the stochastic signal based on the price action of the currency pair.

If you are just starting out, you can stick to using the 14 period setting. However, if you already have some experience trading, it might be a good idea to spend some time back testing a currency pair and try to find an optimal time period range to calculate the Stochastic Oscillator values for that particular Forex pair. When the Stochastic Oscillator was first invented, it was calculated using the formula we discussed above.

However, the original Stochastic Oscillator formula seemed too responsive for some stocks and commodities markets, and traders applied an additional 3-period moving average to slow down the responsiveness of the indicator further.

How does the stochastic indicator work?

This value represents the additional moving average applied to the Stochastic Oscillator to make it a bit less responsive to price action, which results in a more measured output that helps improve the quality of the Stochastic Oscillator signals. When you use an additional moving average to slow down the original Stochastic Oscillator formula, it is called a slow stochastic. Hence, by default, the MetaTrader 4 trading platform shows a slow stochastic based on an additional 3 period moving average. On the other hand, if you stick to the original Stochastic Oscillator formula, then it would be called a fast stochastic.

To calculate a fast stochastic using MetaTrader 4 and other charting software, you need to set the value of slowing to 1. The Stochastic Oscillator offers Forex traders three different types of signals. Depending on the market conditions, these three signals can be interpreted differently.

Therefore, it is imperative that you learn to identify the market condition before trying to interpret the Stochastic Oscillator signals. Often the most used Stochastic Oscillator signal is the overbought and oversold market conditions. As we discussed earlier, the Stochastic Oscillator is plotted on a fixed scale, and its value stays within 0 and When the Stochastic Oscillator value goes above the reading of 80, it is considered to be an overbought market condition, which signals that if you already have a long position, you should start reducing your position size or actively look for opportunities to sell the underlying asset.

By contrast, when the Stochastic Oscillator value goes below the reading of 20, it is considered to be an oversold market condition, which signals that if you already have a short position, you should start reducing your position size or actively look for opportunities to buy the underlying asset.

While the overbought and oversold signals generated by the Stochastic Oscillator is quite reliable, it is worth noting that these signals work best during a range bound market. However, during an uptrend market, the Stochastic Oscillator becomes overbought, and during a downtrend market, the Stochastic Oscillator becomes oversold very quickly and gives an illusion that the market is about to reverse.

Beginner Forex traders often complain that they placed a buy or sell order during an uptrend or downtrend after seeing an overbought or oversold signal generated by the Stochastic Oscillator, which resulted in a loss. If you decide to counter trend trade using the Stochastic Oscillator signals during a trending market, you will get beat up quite badly. During a trending market, you should apply additional filters such as trend lines and other trend reversal indicators to confirm if the trend is ending or it has already reversed before taking counter trend Stochastic Oscillator signals seriously.

Once again, these Stochastic Oscillator crossover signals are reliable during a range bound market, but these signals tend to become a lot less reliable when the market is in a strong trend. However, you can still rely on the Stochastic Oscillator crossover signals as a trend continuation signal and open additional positions.

It indicated that the uptrend is likely to continue and the market did continue upwards. Similarly, if you see a crossover sell signal during a downtrend, you can also rely on the signal as supporting evidence that the downtrend is likely to continue. This type of trend continuation signal tends to be reliable during trending markets. However, you should take caution and apply additional filters before trading against the trend using the Stochastic Oscillator crossover signal.

The last type of signal generated by the Stochastic Oscillator is called divergence signals. Stochastic Oscillator can generate both trend reversal and trend continuation divergence signals. The trend reversal signal is referred to as regular divergence signals, and the trend continuation signal is known as hidden divergence signals. The stochastic divergence signals tend to be the most powerful and reliable of all the different types of Stochastics generated signals.

When price makes a lower low, but the stochastic oscillator fails to confirm and instead makes a higher low, this is considered a Bullish Stochastic Divergence signal. When price makes a higher high, but the stochastic oscillator fails to confirm and instead make a lower high, this is considered a Bearish Stochastic Divergence signal.

Such conditions are known as a trend reversal divergence signal. You can learn more about our cookie policy here , or by following the link at the bottom of any page on our site. Note: Low and High figures are for the trading day. The stochastic oscillator is a useful indicator when it comes to assessing momentum or trend strength. The stochastic oscillator, and oscillators in general, are presented in an easy to understand manner with clear buy and sell signals.

However, an overreliance on these signals, without a deeper understanding of stochastic oscillators, is likely to end in frustration. To avoid such frustration, new traders ought to have a solid understanding of the underlying mechanics of the stochastic oscillator viewed in relation to present market conditions. A stochastic oscillator is a momentum indicator that calculates whether the price of a security is overbought or oversold when compared to price movement over a specified period.

The oscillator essentially weighs up the most recent price level as a percentage of the range highest high — lowest low over a defined period of time. Furthermore, the stochastic indicator provides great insight when timing entries. Traders need to understand the direction of the overall trend and filter trades accordingly. Only when the trend reverses or a trading range is well-established, should traders look for long entries in oversold conditions.

The below calculation is presented for a period stochastic indicator but ultimately, can be tailored to any desired time frame. Traders ought to understand where the stochastic oscillator excels and where its short-comings lie, in order to get the most out of the indicator. The stochastic indicator is a great tool for identifying overbought and oversold conditions over a specific time period. However, traders need to avoid blindly shorting at overbought levels in upward trending markets; and going long in down trending markets purely based on oversold conditions shown by the indicator.

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets. Leveraged trading in foreign currency or off-exchange products on margin carries significant risk and may not be suitable for all investors. We advise you to carefully consider whether trading is appropriate for you based on your personal circumstances.

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