Oscillator that traders need to know: What is Stochastic and how to use it

Stochastic Oscillator (STO) is a technical analysis tool that has been around for over 70 years but remains a key choice for traders worldwide. Its popularity stems from its ability to identify price momentum and trend reversal points. However, many users only utilize it superficially without deep understanding. This time, we will thoroughly explore this indicator.

What is the Stochastic Oscillator really?

The Stochastic Oscillator is a momentum indicator that measures the position of the closing price relative to the high and low range over a period, showing values between 0 – 100.

In this oscillator, clear movement patterns can be observed:

• In an uptrend: Prices make new highs continuously, closing near the high of the 14-period range, causing the STO value to approach 100.
• In a downtrend: Prices make new lows continuously, closing near the low of the range, causing the STO value to approach 0.

The main benefit of this indicator is to identify overbought and oversold zones using %K, indicating when prices are overbought (Overbought) when above 80, and oversold (Oversold) when below 20. Additionally, the %D (the average of %K) can be used to observe momentum changes.

Simple calculation formula of the Oscillator

This tool consists of two main parts: %K (main value) and %D (3-day moving average).

%K = [(C – L14) / (H14 – L14)] × 100

where:

• C = current closing price
• L14 = lowest price in the 14-period range
• H14 = highest price in the 14-period range

%D = (current %K + %K yesterday + %K 2 days ago) / 3

Example from WTI oil data: On 8/9/2023, closing price was 84.4, H14=84.4, L14=77.07, resulting in %K = 100, indicating the price is at the highest point of the range.

Fast Stochastic vs Slow Stochastic: What’s the difference?

Fast Stochastic calculates directly from the latest prices, making it change rapidly. If the closing price equals the highest price, %K will immediately be 100.

Slow Stochastic calculates from the average of Fast Stochastic, which:

• Smoothers the line
• Provides later signals
• Reduces false signals
• Suitable for medium-term analysis

4 ways to read and use the Stochastic Oscillator

( 1. Trend Identification )

Determining price direction by comparing %K and %D:

• %K > %D: Price is above its average → Uptrend
• %K < %D: Price is below its average → Downtrend

Caution: This method works well for short-term signals; in the long term, it can produce many false signals.

( 2. Measuring Momentum Strength

Observed from the gap between %K and %D:

• Wide gap: Strong momentum, trend accelerating
• Narrowing gap: Weakening momentum, potential reversal approaching

) 3. Overbought/Oversold Zones (

Most popular usage:

• %K > 80: Overbought → Price is too high, avoid buying
• %K < 20: Oversold → Price is too low, avoid selling

These zones signal potential major reversals.

) 4. Divergence ###

Includes 2 types:

Bearish Divergence:

• Price makes new highs, but %K makes lower highs
• Weakens sell signal → Possible trend reversal downward

Bullish Divergence:

• Price makes new lows, but %K makes higher lows
• Buy signal → Possible trend reversal upward

Strengths and limitations

( Advantages ✓ Easy to calculate and interpret – uses only 3 variables ✓ Effective in identifying price zones – clear overbought/oversold signals ✓ Useful for short-term trading – suitable for Day Trading

) Limitations ✗ Lagging indicator – signals are delayed, confirmation needed ✗ Uses limited data – not suitable for large trend analysis ✗ Frequent false signals – relying on only one indicator can lead to losses

Combining with other technical analysis tools

1. Stochastic + EMA

Use EMA to identify trend + Stochastic to confirm entry points:

• Price crossing above EMA = buy opportunity ###wait for %K crossing above %D###
• Price crossing below EMA = sell opportunity (wait for %K crossing below %D)

2. Stochastic + RSI

Use RSI to confirm overbought/oversold strength + Stochastic for entry signals:

• RSI > 50 + %K > %D = buy zone
• RSI < 50 + %K < %D = sell zone

3. Stochastic + MACD

Use MACD to indicate momentum + Stochastic for reversal points:

• MACD crossover upward + %K crossing upward from Oversold = strong buy signal
• MACD crossover downward + %K crossing downward from Overbought = strong sell signal

4. Stochastic + Price Pattern

Use price pattern to identify formations + Stochastic to time entries:

• When a reversal or breakout pattern appears
• Confirm with Stochastic divergence or crossovers

Example: During a triangle pattern, if %K crosses above %D from Oversold with green candles, it’s a buy signal.

Example of GBP/USD trading strategy

Tools: Stochastic###14,1,5( + EMA)75###
Timeframe: 5 minutes

1. Step 1: Price drops below EMA75 → look for sell opportunity
2. Step 2: Wait until %K crosses below %D from the Overbought zone → open Short
3. Step 3: Close Short when %K crosses above %D from the Oversold zone

Result: Profitable quick short-term movement.

Important points to remember

• Stochastic is not a perfect buy/sell signal alone.
• Always combine with other technical tools for confirmation.
• Adjust parameters to suit your timeframe.
• Test thoroughly before risking real money.
• Trading success = using the right indicator + risk management + trader psychology.

Summary

The Stochastic Oscillator remains a valuable tool for traders, but it’s important to understand that it is just one of many tools. Successful trading results from multi-dimensional analysis, good risk management, and repeated practice, then scaling up gradually.