Use The Fast Or Slow Stochastic Oscillator The Right Way

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As with any technical analysis trading indicator, the Slow Stochastic Oscillator is only a tool and should only be used as part of an overall trading strategy.

I’m not going to draw a conclusion for you as to the effectiveness but will cover how you can trade with the slow Stochastic Oscillator and everything covered can also be used with the Fast Stochastic Oscillator.

I prefer the the slow version of the Stochastic mainly due to the smoothness of the indicator.

 

What Is The Slow Stochastic Oscillator

The Stochastic is a momentum indicator and the Stochastic is designed to give you an objective measure of the momentum in your trading instrument. It’s bounded by the numbers 0 and 100 and will oscillate between those two areas.

One area you want to be clear on is that simply because the lines on the slow Stochastic indicator moves up and down, it does not always track price movement.

Remember, it measures momentum in that it tells you via the direction if price is closing closer to the highs or lows over a set period of time.

Some will say that it is an oversold/overbought indicator however that was not the original intention of the indicator. George Lane, the developer of the indicator, actually used it for stochastic divergence – the divergence of the Stochastic when compared to price.

There is a big issue even when using the Stochastic as intended but for now, just keep in mind that we are looking at momentum in the market when using this indicator.

 

Stochastic Oscillator Formula

You may find different calculations depending on the charting package that you are using however this is the proper formula for the fast Stochastic.

%K=(C-L)/(H-L) ×100 C=Close is current closing price L=Lowest low over X periods. H=Highest high over X periods

The slow Stochastic is calculated differently where %K is a 3-period moving average of the fast %K. %D is an x-period moving average of the fast %K.

Keep things simple.

Even if your charting platform has a different calculation, just use what is available.

Remember that any trading indicator is simply one cog in the wheel of a complete trading system. You will probably not rely on one thing to indicate a trading opportunity.

 

What Is The Best Settings For The Slow Stochastic?

Many trading indicators will give you the opportunity to adjust many of the inputs that will be used in the calculation. This can be a good thing when trying to optimize for current market conditions but it can produce more headaches than trading results.

If 14, 3, 3 is a great setting, why not 13?

What about 5, 3, 3?

What about any combination you can think of?

Keep in mind that the shorter the look-back period, the more movement you will get with the indicator.  A setting of 14 will be slower than a 5.

Whatever you determine works for you, just be consistent.

One of the reasons I prefer the slow Stochastic is I find it plots smoother on the charts. The fast Stochastic is ragged in appearance which has to do with it being more sensitive than the slow version of the indicator.

There is no best Stochastic setting that will produce more wins than losses.

Most of the time, the best stochastic setting is actually the default settings. The amount of time you spend trying to optimize the settings is better spent seeing how the indicator reacts to the price movements.

Far too many traders think they will need one setting for day trading, one Stochastic setting for swing trading, for scalping, for different time frames. Don’t get caught in that rabbit hole.

 

Stochastic Oscillator Strategies For Swing Trading or Day Trading.

Now that we know that the Stochastic is a momentum oscillator that measures the momentum of the last X periods (look back), let’s look at some uses of the indicator.

There are dangers when trading the often touted methods without taking a more critical look at what not only what the indicator is telling you, but what price action and structure is telling you.

Ensure you use any trading indicator in the context of an overall trading plan. Price action is often one way traders will utilize a trading indicator when trading.

 

Overbought and Oversold Stochastic

This is something you read about quite a lot and often times it misses the truth about these levels. These are not areas you simply want to execute a counter trade position. Remember, this is a momentum indicator and overbought and oversold territory can often mean this is a strong market.

But it doesn’t mean the move will continue. There will be times that a reversal will correlate to an oversold or overbought Stochastic reading.

overbought oversold slow stochastic oscillator

We are looking at momentum and when momentum is high enough to force the Stochastic lines into either of these levels, it indicates strength/weakness and if you’ve traded long enough, this can indicate the market is primed for a reversal.

This chart shows a market in both conditions and you can see that:

  • Overbought – The market changes direction and the last “reversal” would have had you exiting any short positions
  • Oversold – Market reverses but if you notice the first reversal to the upside, we didn’t need an oversold condition to start the move.

Is taking a trade simply because of the trading signal of the Stochastic a good idea? In this case there were some trading opportunities but this should lead you to go and find where this fails.

When back testing anything in trading, ensure you are seeing the whole picture and not just what you want to see.

When you see this condition, think of it telling you that at this point, the market is probably in a strong directional trend and barring any strong support or resistance, it will probably continue in that direction.

Why probably?

An object in motion stays in motion with the same speed and in the same direction unless acted upon by an unbalanced force – Newton

You will get counter moves (unbalanced force) that may slow down the momentum of the market but to reverse it, that force must be strong. That strength is often found at historical structure points.

 

Look For Confluence On Your Charts

You may find opportunities when a confluence of technical factors line up when the market is oversold or overbought. This may be an opportunity to pull some profits out of the market but you want to watch how price reacts around these areas. It must show some sign of weakness in order for you to find yourself in a higher probability trade.

There are plenty of opportunities for trades while the market in both states in this example. I can see range failure tests, range breaks, and even engulfing candlestick patters broken with strength and this is only using this time frame.

The key is using your trade plan to dictate your trading setups, finding them in favorable conditions, and executing them.

 

Divergence Trading With Slow Stochastic

Price goes one way and the Stochastic goes another, divergence is usually the play traders look for. This was the original play that Lane was looking at when developing the Stochastic but like I keep saying, an indicator signal by itself is not always the smartest opportunity.

stochastic divergence

  1. If price is in downtrend, compare lows of price and Stochastic
  2. If price is in uptrend, compare highs of price and Stochastic
  3. If price makes lower low but Stochastic makes higher low, consider longs
  4. If price makes higher higher but Stochastic makes lower high, consider shorts

This is down trending price and you can see that price puts in a low lower than the previous low. The Stochastic puts in a higher low which indicates the potential for a move up in price.

An uptrend would be the opposite. Price would make a higher high but the Stochastic Oscillator would put in a lower high.

Remember that the Stochastic measures momentum and even though price is moving down, the momentum calculation is pointing to the upside. It does not mean we are about to have a strong trend to the upside.

 

Stochastic And Price Trend

One component of a Stochastic oscillator trading strategy you may want to employ is an objective measure of the quality of the price trend and the trend direction itself.

If the price is trending to the downside, your trading plan may call for continued short positions instead of counter trend trades. All trends are not created equally and the Stochastic will help you determine the quality of the momentum of the trend.

slow stochastic trend

The first green area shows the Stochastic pointing to the down side. You would only be looking for a sell signal when this is the market condition.

More importantly, look at the separation of the slow and fast line of the indicator. That indicates that there is a nice smooth trend in play.  A slow Stochastic trend is the momentum trend and for this, you may want to consider using an MTF (multiple time frame) approach in your trade plan.

Essentially we are looking for the momentum direction on a higher time frame and looking for trades on lower time frames in the same direction.

When using a multiple time frame trading approach, look for a difference of 3-5 times. For example, you can use a 60-minute trend for trades on the 15-minute time frame. For simplicity, traders may look at the daily chart for the momentum trend while in Forex, some traders use the daily-4 hour combo and the 4 hour-1 hour combo.

 

Trading In Chop

The red area shows the Stochastic slow and fast lines tight together with many crosses of each line.  Look at the price action during this time and that shows a market where there bulls and bears are in an almost equal battle.

Is that condition conducive to pain free trading?  This may be a time where you sit on your hands or, depending on your trading plan, look at a different time frame combination to trade.

 

Back To The Trend

Once the fast line crosses up and over the slow line, we can objectively state we are in an uptrend.  Look again at the nice separation between the slow and fast lines.  This makes for virtually ideal trading conditions.

Look for a separation between the lines as well as sweeping up or down moves of the Stochastic to indicate a trend quality that you may find conducive to better trading opportunities.

 

Stochastic Crosses With Technical Analysis & Price

We can take some of what we have covered and add a few layers of confluence to it that may add to the probability of some price movement in our favor. To do so, we are going to add in some price structure to aid us in a trading decision.

Trading an indicator buy or sell signal blindly is a recipe for disaster but adding in what the chart itself has to offer is a totally different ballgame.

This is why Netpicks always incorporates 10-20% non-mechanical variables into each and every trading system and plan.

Do you trade that whenever it occurs?

Of course not.

This chart has a few examples using horizontal support and resistance.  We also see trend lines in action as well reversal candlesticks.  Make sure you look to the Stochastic to see the buy and sell signals that were given while we also had technical confluence.

Slow stochastic trading conditions
Slow stochastic trading conditions

This was making a case for trading as opposed to just firing off a trade because the trading indicator gave a typical (and textbook) signal.

When you add in a confluence of factors including price structures, you improve your odds of some move in your favor. Nothing is perfect so having a trading plan that includes risk tolerance and trade management is extremely vital.

 

Indicators Just Part Of The Trading Puzzle

There are still many people who believe you can simply apply an indicator to a trading chart and take the signals when presented.

As pointed out, to do so will not equate to a positive trading outcome. You need more.

Simply applying the basics such as support and resistance or trend lines will, at least, give you something to trade against. They can also keep you out of taking trades directly into points of the chart that may offer some opposing forces that will challenge your trades.

You want to ensure that any trading system you use that has indicators is also thoroughly tested and if based on multiple indicators, that they compliment each other. Having two momentum indicators, for example, is not needed and just adds a layer of complexity to any trading strategy.

Remember one of the key elements of a trading plan is how you manage your trades and the risk you will take. Those are as crucial, if not more so, than what setups you use for your trades.

Whether you use the slow Stochastic as part of your trading plan or any other indicator, ensure that you critically analyze the information it presents so you can see both the pros and cons of each. Testing a trading system and each variable is hard and tedious work.

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CoachShane

Trader at Netpicks
Shane his trading journey in 2005, became a Netpicks customer in 2008 needing structure in his trading approach. His focus is on the technical side of trading filtering in a macro overview and credits a handful of traders that have heavily influenced his relaxed approach to trading. Shane started day trading Forex but has since transitioned to a swing/position focus in most markets including commodities and futures. This has allowed less time in front of the computer without an adverse affect on returns.

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