Stochastic Oscillator: A Mechanical Indicator for All Traders
Stochastic Oscillator is almost the most famous indicator among stock traders. As many of the professional currency traders have been professional stock traders in the past and they still trade stocks as well, they are used to use this indicator on their charts. They are somehow addicted to Stochastic Oscillator.
The question is whether Stochastic Oscillator is really a good indicator or not?
I believe all indicators and even trading strategies are good (1) when you know how to use them properly, and (2) you wait for the strong trade setups. If not, you lose with any trading strategy and indicator.
So, first you have to master your trading strategy and the trading tools and indicators it has, and then you have to wait for the strongest trade setups and ignore the weak and questionable ones. If so, you will make profit, no matter what trading strategy and indicator you are using. If not, you will lose, no matter you have the best trading strategies, indicators, software, and&8230; .
Stochastic Oscillator is not an exception. Many traders know this indicator as a money sucker, but I believe all indicators, even candlesticks that are my favorite trading tools, can be terrible money suckers when you don&8217;t know how to use them properly, and when you don&8217;t wait for them to form good and strong trade setups.
To become a consistently profitable trader, first you have to master your trading strategy and the indicators it has.
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What Is Stochastic Oscillator Indicator?
Stochastic Oscillator is an oscillator that records the price fluctuations and speed which is known as momentum.
The Stochastic Oscillator formula doesn&8217;t tell you whether you should use this indicator or not. Any indicator has a special formula which is different from the other indicators. What has made Stochastic Oscillator different from the other indicators is that, it doesn&8217;t roughly follow the price, like what many other indicators do. It tracks the speed of the price changes which is also known as momentum.
The most important point here is that, as the momentum changes before the price changes its direction, you can make big mistakes if you enter the market right after Stochastic changes its direction. This is how most traders lose when they use Stochastic, whereas the problem is in the way they use this indicator, not in the indicator itself.
The most important part of Stochastic is the %K parameter. It is set to 14 by default and most stock traders use this settings, but on MT4 platform it is set to 5. However, it doesn&8217;t make a big difference actually, at least in the way that I am going to show you to use it.
Like RSI, Stochastic Oscillator goes to overbought and oversold areas. When the price goes up for a few candlesticks, Stochastic Oscillator goes to the overbought area which is above the 80 level, and when the price goes down for a few candlestick, Stochastic Oscillator goes to oversold area which is below the 20 level.
Some traders are used to change these levels to 70 and 30 to filter out some of the false trade setups, but this is not a good idea and we really don&8217;t have to do that, because as I mentioned earlier in this article, Stochastic Oscillator&8217;s application is completely different from what most traders think. Stochastic Oscillator is an indicator to follow the price speed, not the price movements.
As you see on the above chart, Stochastic is used to go up and down between the 20 and 80 levels. Most traders think that they should buy when Stochastic Oscillator changes its direction and goes up from the oversold area, and they should sell when it changes its direction and goes down from the overbought area. This is a big mistake, because the price can keep on going down for such a long time, even when Stochastic goes up and leaves the oversold area. It can also go up for so many more candlesticks, even when Stochastic goes down and leaves the overbought area.
How to Use Stochastic Oscillator
Here, I am going to teach you how to use Stochastic Oscillator in a completely mechanical trading system. If you like to use this system, you have to forget everything you already know about this indicator, and try to use it in a completely new way which is in fact the real way that Stochastic Oscillator has to be used.
Stochastic Oscillator cannot be the only indicator that tells you when to buy and sell. It was not created to do that. It has to be used along with the price actions. If you look at Stochastic Oscillator only to get in or out of the market, you will lose, even if you have the other Oscillator indicators like RSI and MACD on your charts. It is almost the same with all the other Oscillators. You have to use them along with the price actions. It is the price action that has to give you a buy or sell signal first. Then you have to refer to the indicator and find out whether it also confirms the price action or not.
What Is the Price Action I Am Talking About?
Experience shows that in case of Stochastic Oscillator, nothing is better than support and resistance breakouts. However, to keep the trading system as simple and mechanical as possible, we mainly focus on the support and resistance levels, but I will also show you some examples from the support and resistance lines.
So, here is what you have to do:
1) Open a price chart and add the Stochastic Oscillator on it. You can make the signal line invisible, because we only need the main indicator line. If you are using MT4 platform, then leave the parameters to have the default settings which is 5, 3, 3.
This is how you can make the signal line invisible:
2) Refer to the weekly chart and zoom out to see the candlesticks as short and thin lines. This helps you to see the strong, valid and most visible support and resistance levels better.
Why weekly chart?
I said weekly chart because this system works much better on this time frame and also the monthly. Indeed, all systems work on the longer time frames better and this system is not an exception. However, I will show you some examples of using this system on the daily chart, specially to follow the trends.
3) Look for the most recent and strongest support and resistance levels and plot horizontal lines below/above them.
As you see on the below chart which is related to EUR/USD weekly chart, there are two strong support levels that are so close to each other. One is at 1.1884 and the other one at 1.2041:
4) Wait for one of the candlesticks to close above a resistance or below a support level. That means the price action we were looking for, is formed.
5) At the same time that a candlestick closes above a resistance or below a support level, Stochastic Oscillator has to be in the overbought or oversold area respectively.
A long trade setup or buy signal forms when (1) a candlestick closes above a resistance level and (2) Stochastic Oscillator is in the overbought area at the same time.
A short trade setup or sell signal forms when (1) a candlestick closes below a support level and (2) Stochastic Oscillator is in the oversold area at the same time.
It is as simple as that. The most important thing in this trading system is that you locate the strongest and most visible highs and lows to plot the resistance and support levels. You should be careful not to take the weak levels breakouts.
Let&8217;s get back to the above screenshot as an example. As you saw, we located two strong support levels at 1.1884 and 1.2041. According to what I explained above, if any of the candlesticks closes below one of these support levels while Stochastic Oscillator is in the oversold area, we will have a short trade setup:
Below, is a resistance level on GBP/JPY weekly chart:
And this is how the resistance level was broken and a long trade setup formed:
Another long trade setup on EUR/AUD weekly chart:
Why Do We Need the Stochastic Oscillator Confirmation?
Almost in all the strong support and resistance levels breakouts, Stochastic Oscillator is already where it has to be. It is in overbought area when a strong resistance level, and in oversold area when a strong support level, gets broken. So, Stochastic Oscillator confirms 100% of the strong support/resistance levels breakouts. If so, then we don&8217;t have to have it on the charts. We just need to wait for the strong support/resistance levels to get broken, and so we enter. Is the correct?
That is right, but we take the Stochastic Oscillator confirmation to filter out weak levels breakouts. Novice traders usually have a hard time locating the valid and strong levels. They don&8217;t know how to zoom out to see the bigger picture of the markets, the strong highs and lows, and so the strong breakouts. They don&8217;t know how to do it technically, and they are not patient enough to wait for the strong levels to form and get broken. So, they locate weak and invalid levels and get in after their breakout. It is when Stochastic Oscillator can prevent them.
If you are skilled enough in locating the strong and valid levels, then you don&8217;t need to have the Stochastic Oscillator indicator on your charts. If you like to have it, then you should use it the way I explained above.
False Long Trade Setup Breakout:
Most traders think that they have to go long when Stochastic Oscillator turns around to go up and leave the oversold area. If you do so, you will have so many losing positions, because the price can keep on going down even when Stochastic Oscillator turns around and starts going up from the oversold area. It can go up a little and then go down to reach the oversold area again. It can repeat this for several candlesticks. It is the same when Stochastic is in the overbought area.
That is how most traders who use Stochastic, lose a lot of money. They want to hit the top and bottom of the movements, and so they go long or short, as soon as Stochastic leaves the oversold and overbought areas. That is why professional traders say that trading is not about buying low and selling high, or selling high and buying low. Trading is about buying high and selling higher and selling low and buying lower. Why?
The reason is that first you have to wait for a party to take the full control. You should go long only when you are sure that bulls have taken the full control and will take the price higher. You should go short only when bears have the full control. A bullish candlestick that causes the Stochastic Oscillator to turn around and leave the oversold area, doesn&8217;t mean that bulls have the full control. If you get in because of that, most probably you will lose. Most traders who use Stochastic Oscillator indicator lose because of these mistakes, and then will call the indicator &8220;money sucker&8221; after a while. Stochastic is not a money sucker. It is those traders who don&8217;t know how to use it properly.
As you saw, you should enter only when Stochastic Oscillator is in overbought or oversold area. You have to stay away from the market when Stochastic Oscillator turns around and is moving between the 20 and 80 levels. This is how it works.
Where to Place the Stop Loss and Target Orders?
When you go long, you should place the stop loss a little below the low price of the candlestick which has broken above the resistance level. When you go short, you should place the stop loss a little above the high price of the candlestick which has broken below the support level.
That is a reasonable stop loss in this trading strategy. When the breakout candlestick is too short, you can have a wider stop loss, probably above/below the high/low price of a few candlesticks before the breakout candlestick. It depends on the case and the trade setup.
Target order is a more complicated discussion in any trading system. Entry and stop loss can have clear and strict rules, but the question which is harder to answer is the exit. Where is the best level to get out?
Your target order can be from x1 to x10 of your stop loss. I suggest you to move the stop loss to breakeven when the price moves accordingly for x1 or x2 of your stop loss size. When you move the stop loss to breakeven, then there is no risk to hold the position. I suggest you not to get out with less than x5 profit. If you choose the strong and valid levels and then you enter on time after the breakout, you can make thousands of pips. Of course you have to follow the longer time frames if you want to be such a profitable trader.
To have a good understanding from the best exit levels, you have to know many other things. When you are following a trend, you should know about the Elliott Wave Theory to know when the trend is exhausted and it is the best time to exit. More professional traders have learned to enter based on a shorter time frame trade setup, but hold the position based on longer time frame, to maximize the profit as much as possible. For example, they get in based on the daily chart, but then hold based on the weekly and monthly, when they see that the trade setup that was formed on the daily chart, turned to a strong trend not only on the daily, but also on the weekly and monthly charts.
Novice traders need some time to learn all these things. When they are learning, they can still enter the markets based on the strong trade setups I explained above, and enjoy collecting x5 profits. They will learn to let their profit grow even more, when they become more experienced.
Trading the Support and Resistance Lines Breakouts
In addition to support and resistance levels, you can trade the support and resistance lines through this system and using the Stochastic Oscillator indicator. However, you have to note that locating and plotting the valid and strong support and resistance lines needs more experience and knowledge and is a tricky task compared to support and resistance levels. You will have more losing positions if you want to trade the support and resistance lines.
The same rules have to be applied here too. You can go long when a candlestick breaks above a resistance line and Stochastic Oscillator is in the overbought area at the same time. In case of the short positions, a candlestick has to close below a support line, and the Stochastic Oscillator has to be in the oversold area at the same time.
A False Long Trade Setup:
The below chart shows that a candlestick closed above a resistance line while the Stochastic Oscillator had not reached the overbought area. As you see, the price went down and retested the broken resistance line strongly after the resistance breakout:
A True Long Trade Setup:
The below screenshot is self-explanatory. A good and valid resistance breakout which is later confirmed by valid and precise retesting, while Stochastic Oscillator is where it has to be. As you see, Stochastic Oscillator can be a great tool, if used properly:
A Good and Valid Short Trade Setup:
Following the Trends
Trading the strong levels breakouts along with Stochastic Oscillator confirmation is a great way to follow the strong and continued trends. When it is proven that there is an ongoing strong trend, you can enter after the smaller levels breakouts on the same trend. If you set a proper stop loss in the way that was explained above, you will get out with a small loss in case the trend reverses. However, you will have a strongly profitable position if the trend continues.
As you see on the below screenshot, a resistance breakout ended to the too strong uptrend on USD/JPY weekly chart (1). At the middle of the way, a resistance level formed at 103.726. It got broken later (2), but then the market went sideways and hit the stop loss. After that, another resistance level formed at 105.433 that got broken several candlesticks later (3), and although the price retested the level, it went up over 1800 pips after that. So those who had missed the trend, could get in at the middle of the way.
The below screenshot shows the support levels that could be traded during a strong downtrend on EUR/USD daily chart. Although your stop loss can get hit sometimes, you can recover the losses through the several winning trades that a strong trend can give you:
Why Was This Article Written?
This article was written to give a detailed and complete answer to those traders who always ask about Stochastic Oscillator, its settings and the way it can be used. As I explained at the beginning of this article, Stochastic Oscillator is a popular indicator among traders, specially the stock traders. However, there are very few traders who know how to use this indicator properly, and so, 99% of those who use this indicator, always lose.
In this article, I introduced a simple and mechanical, yet strong, profitable and effective way to enter the markets using the price action (which is the best and most effective way to trade), and Stochastic Oscillator confirmation. Those traders who like to have more trading opportunities can use this system along with the other systems they use. If they follow the weekly and monthly charts, all they have to do is spending half an hour every weekend, to locate the forming and formed trade setups, and then entering the markets at the market open on Sunday afternoons.