Using a Stochastic Oscillator – the Basics

This may or may not be reflected in the price moves, but is nonetheless a warning sign to avoid buying call options, or potentially start watching for puts. When the price reaches or exceeds a prior swing high in price, while the stochastic oscillator does not, that is called negative divergence. It’s a warning sign that the uptrend may be exhausted.

The same concept applies to the stochastic oscillator making a higher low when the price reaches or drops below its prior swing low.

Here’s an example on the 1-minute chart where Tesla (TSLA) has a big rally and the Stochastic reaches 95.91. On the next rally, the Stochastic reached 98.62. The price on the second rally nearly reaches the prior high. No divergence yet. On the third rally, the price reaches the prior high, but the stochastic only reaches a high of 92.2.

Once this occurs, enter a put trade as the price drops below the prior candlestick low. The short trade occurred just below $225 on the large red candle.

Since this is a 1-minute chart, the strategy is useful for expiries that are one to several minutes away. The strategy is capturing a price reversal as momentum is fading, but it is unknown how long the price reversal will last.

This strategy utilizes both price action and the indicator. Divergence trades don’t occur very often on intraday charts, which limits its usefulness. Stochastic divergence is more common on daily charts.

Here is a daily chart of Tesla. The Stochastic indicator is moving up as the price forms a new low. When you see this, you can consider placing a call trade when and if the price moves above the prior candlestick high.

Once we can see the divergence, which shows selling is slowing AND the price clears above the high of the prior candle, you should consider a call or long trade.

Without further analysis, it is unknown how long the rally will last. Therefore, expiries one to two days out are best for daily chart signals.

For reference, the Stochastic Oscillator is the blue or faster moving line on the charts above. The orange line, which is slower, shows the moving average of the Stochastic. For the divergence strategy, only the Stochastic Oscillator reading matters.

Below 20 is called oversold and above 80 is called overbought — but this doesn’t mean we should act. It just means the price is trading in the lower or upper portion of the last 14 periods. What is more interesting is when the price moves out of the overbought or oversold area, especially if there is a visible overall trend occurring. Here’s what I mean.

When the price is declining, the oscillator will often struggle to reach 50, let alone 80. When the price is trending higher, the oscillator will often struggle to fall to 50, let alone 20. So how should this inform your next move?

• When you can visually see that the price is dropping, watch for the Stochastic oscillator to reach 50 to 70.

• Wait till the Stochastic turns lower and the price drops below the prior candlestick low. Enter a put trade with an expiration of one minute to a few minutes away.

If the stochastic shoots above 80, I would avoid this strategy until you see the price falling again. You’re watching for the indicator to move into the 50 to 70 range and then take a dip. Let’s look at an example on the EURUSD 1-minute chart, for all the forex traders out there.

For the first trade, the price has been dropping. The stochastic moves above 50 and turns lower, but ultimately the price keeps going up. Losing trades happen. No worries.

“In this business, if you’re good, you’re right six times out of ten. You’re never going to be right nine times out of ten.” – Peter Lynch

The price continues lower so we start looking for signals again. The next two trades are winners as the price moves to the downside; it doesn’t return to the entry point within several minutes.

The price rallies and the stochastic shoots above 80. You should not trade at this point, until you have mastered how to trade uptrends – which is covered next.

“There is a time to go long, a time to go short, and a time to go fishing.” – Jesse Livermore

As the price starts falling again, look for the signals. Two more short trades or put signals occur as the stochastic reaches 50 (but not above 70) and then turns lower while the price drops below the low of the prior candle.

For going long, we want to see the price rising.

• We are looking to buy when the price pulls back between 50 and 30 levels on the stochastic.
• Buy when the price moves above the high of the prior candle and the stochastic makes an upward turn.

The expiry should be one to a few minutes away (or one to a few candles away, depending on the chart time frame you are trading).

This strategy does take some practice. When I started trading 18 years ago, I used to have a stochastic on my chart. I used it as a general guide to alert me when the price was pulling back within the trend. Over time, I have learned to see it without using the indicator, but early on, it can help train your eye to spot some trading opportunities.

I like this strategy because it highlights that are overbought and oversold levels can vary based on the trend. During an uptrend, 50 to 30 is often oversold and ready to bounce. During a downtrend, 50 to 70 is often overbought and really to sell off.

We don’t actually need the more extreme levels of 20 and 80 to give us signals. For more strategy ideas, learn these classic chart patterns.

Here is the stochastic oscillator formula.

%K = (Current Price – Low) / (High – Low) * 100

%D = 3-period simple moving average of %K

Low = the lowest price over the last 14 periods

High = the highest price over the last 14 periods

3-period simple moving average = the last three %K values summed up and then divided 3

Understanding how the indicator is structured is beneficial. From the calculation, we can see the indicator is showing us where the current price is relative to the high and low over the last 14 periods.

Decreasing the number of periods, to five for example, will cause the indicator to move up and down more quickly. This may be useful for people who want to make quick trades and get more trading signals.

Increasing the number, to 20 for example, will make the indicator move up and down more slowly. There will be fewer overbought and oversold readings, but potentially more divergence signals.

Do I need to use a Stochastic Oscillator to trade?

Using a stochastic indicator is not required for successful trading. If you find it helps you make better trading decisions, use it. If it doesn’t help you personally, don’t use it. The same goes for any indicator. Use what you find useful, discard the rest.

Can day trade with a stochastic oscillator?

The stochastic indicator can be used on any time frame. The indicator is measuring where the current price is relative to the last 14 periods. Those periods could be minutes on a 1-minute chart or weeks on a weekly chart. How the indicator is used remains the same.

Does the Stochastic Oscillator predict the market?

The stochastic oscillator is measuring current momentum relative to a recent price range. There is nothing inherently predictive about the calculation. That said, if it helps you pick entry points that make money then it is helping you better forecast the market.

When is the Stochastic indicator not effective?

This depends on how the indicator is used in the first place. During ranges, the extremes may highlight possible turning points. During a downtrend, we may not see many overbought readings but we will see more oversold readings. Then the price reverses into an uptrend, the opposite begins to occur: more overbought readings and fewer oversold readings.

The indicator is always working in that it is producing the numbers it is programmed to produce. We need to learn to interpret them in different market conditions.

What Other Technical Indicators Should I Learn About?

There are many technical indicators, so here are some additional ones you may want to check out, and why. Volume is the fuel behind price moves. Learning about volume indicators can help you assess if the current price move is running on full or empty.

Fractals and the Relative Strength Index (RSI) are two other popular indicators. Fractal Reversals discusses how to combine fractals and reversal into one strategy.

Moving averages are probably the most commonly used indicator of all. Here I break down how moving averages work. Moving averages can provide a simple visual of whether an asset is trending higher or lower.

Final Thoughts

The stochastic oscillator has the primary function of highlighting slowing momentum (divergence) and overbought and oversold levels. Oversold levels during an uptrend may be higher than oversold levels during a downtrend. And during a downtrend, the overbought levels will be lower than during an uptrend.

The key to any indicator is noticing its tendencies and then deciding if using it will aid you in your trading. The stochastic can be useful to signal potential turns in price. Try it out in a demo account first, utilize the strategies discussed, and see how it works for you.