Stochastic Oscillator Complete Trading Guide

The stochastic oscillator is a momentum indicator showing where the closing price is relative to its highs and lows over a set period.  During an uptrend, we will have the closing prices closer to the highs while a downtrend has closing prices near the lows.

It oscillates between 0 and 100 which makes it useful for markets in a trading range with 14 periods as the default lookback setting.  As closing prices begin to fall closer to the lows, the stochastics indicator will show momentum fading from an up trending direction.

The %K and %D lines on the Stochastic indicator (trigger and signal line) moves up and down, but they don’t always track price movement.  This sets up a trading technique called divergence.

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


Stochastic Oscillator Settings and Calculation

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

What is K and D?

+ The %K is a 3-period moving average of the fast %K.

+ %D is an x-period moving average of the fast %K.


In this example, the slow stochastic has a smoother appearance than the fast stochastic.  On this chart while both show similar overbought level, the slow stochastic does not show the same oversold level on the left.

When any technical indicator shows rapid changes, you will often encounter many false signals depending on how you trade.


Stochastic Oscillator Best Settings

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.

One of the reasons I prefer the slow Stochastic is I find it plots smoother on the price charts. 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 Oscillator setting that will produce more wins than losses.

Most of the time, the best stochastic setting is actually the default setting. 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.


Best Stochastic Setting For Day Trading

If you were set on changing the oscillator for day trading, there may be a valid reason – day trading is limited to the session.  This means that you may want a slightly faster trading signal and I would suggest only looking at the lookback period.

In this chart, I have used the slow stochastic setting of 14.3 and 5.3.

day trading settings

You can see the 5.3 stochastic setting on this 15 minute chart stock chart reacts quicker with extreme move to price and in some instances, crosses to the downside.  In fact, it resembles a fast stochastic.  Depending on how you use the oscillator in your trading, there may be validity to a smaller period setting.  Each trader has to decide if the trade-off between quicker signals and more whipsaw to slower signals and smoother price movement, is worth it.

There is no best setting just as there is no best technical indicator.  Minor changes in a lookback period should have very little effect on a robust trading system.


How To Use Stochastic Oscillator 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.

Here are some stochastic oscillator trading strategies you may consider for Forex trading, futures, stocks, or any market of interest.


Trading Overbought and Oversold Conditions

The “stoch” is often used to identify overbought and oversold levels however keep in mind that was not the original use of the indicator.  The stochastic oscillator is a range-bound indicator which means it can oscillate between two extreme levels, 0 and 100.

For the purpose of an oversold or overbought indicator, levels are generally accepted to be:

+ Below 20 is considered oversold

+ Above 80 is consider overbought

Many traders use these oversold and overbought levels to time a trade in the opposite direction of these readings however often times, the market can stay in this condition while the stochastic stays in the oversold/overbought zones.

+ Oversold is below 20 and using a 14-period stochastic look back, price is trading at the low end of the past 14-day range.

+ Overbought is above 80 and using a 14 period look back, price is trading at the high end of the past 14-day range.

This does not mean the market is about to reverse.  It can indicate extreme weakness or strength.  Any interpretation is done by the trader but remember this is a momentum indicator.  Your safest trade would be in the direction of the trend – going long if price action shows a reversal out of an oversold condition, for example.

But it also 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
Oversold and Overbought Stochastic Examples

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 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.

“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.

Using oversold and overbought conditions of the stochastic indicator may have a better edge when trading in the direction of the overall trend.  You can use those readings for trade/risk management purposes such as scaling out or trailing your stop loss.


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 signs 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.


Bullish and Bearish Divergence Trading

George Lane, the developer of the indicator back in the late 1950’s, actually used it for stochastic divergence – the bullish divergence or bearish divergence of the Stochastic when compared to price.

The 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 - Bullish Divergence Example
Bullish Divergence Example

1. If the price is in a downtrend, compare lows of price and Stochastic

2. If the price is in an uptrend, compare highs of price and Stochastic

3. If price makes lower low but Stochastic makes a higher low, consider longs as this could be a bullish divergence and look for a bullish reversal

4. If price makes higher higher but Stochastic makes lower high, consider shorts, as this could be a bearish divergence

This is a 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 indicate the potential for a move up in price – bullish divergence

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 measure’s momentum and even though the 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.


Consider 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 downside. 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) approaches 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 multiple time frame trading approaches, 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.

Once the fast line crosses up and over the slow line, a stochastic crossover, 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.


Trading In Choppy Market Conditions

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.

You can use a choppy market indicator as well, such as the Squeeze, if consolidated markets are something you look for.

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.


Crossover Signal 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.

Since we can use a Stochastic crossover as a trend change signal, we can also use the crossover as a trade entry buy and sell signal.

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

Stochastic Crossover With Technical Analysis & Price
Stochastic Crossover With Technical Analysis & Price

This was making a case for a trade entry 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 movement in your favor. Nothing is perfect so having a trading plan that includes risk tolerance and trade management is extremely vital.

You can also add in the stochastic divergence reading that was covered early as part of the confluence you need to see before taking a trade.


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 trading indicators is also thoroughly tested and if based on multiple indicators, that they complement 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/fast 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.

Author: CoachShane
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.