Stochastic Oscillator Indicator helps to determine when the currency pair is overbought or oversold. Overbought and oversold states indicate an imminent trend reversal. Usually, Stochastic Indicator comes along with the Signal line, which can help to determine even better opportunities to enter the market.
Here we present simple intraday trading strategy, which will help traders to master using Stochastic. The strategy is based on a simple rule: buy when the market is oversold and sell when the market is overbought. Stochastic Oscillator Indicator consists of two lines, %K and %D, and bound between 0 and 100. Line %K stands for Stochastic Oscillator of the price for given period and %D is moving average of %K. When line %K rises above 80 level – market is considered overbought; when %K falls below 20 level – market is considered oversold. With the help of Stochastic Oscillator traders are looking for trend reversal points, trying to catch trend while it is developing.
Signal line %D serve to identify entry points. While %K identify overbought and oversold state of the market, %D shows trends of the indicator itself. One proven method to confirm trading signals from %K is crossing of this lines.
- Any trading instrument is suitable
- To avoid the impact of market noise we recommend to use time frames higher than 15 min
- Install on chart Stochastic Oscillator Indicator with inputs: %K = 14; %D = 3; Slowing = 1
An example of overbought and oversold states of the Stochastic Indicator. Asset: EURUSD; Timeframe: 30 Min; Stochastic: %K = 14, %D = 3, Slowing = 1.
- Stochastic line %K is below oversold level 20 – waiting for Buy signal confirmation
- Line %K crosses Signal line %D bottom-up – open Long position (Buy)
- Stochastic line %K is above overbought level 80 – waiting for Sell signal confirmation
- Line %K crosses Signal line %D from top to bottom – open Short position (Sell)
Initially exit rules underlie evaluation and installation of the Stop Loss and Take Profit levels.
There are several rules to evaluate Stop Loss, which underlay different risk levels. Usually, Stop Loss set to the support levels and pivot points. These rules are listed for the Buy signal, for the Sell signal rules should be vice versa.
- Minimum of the last bar (Suitable for the high time frames, 4h, 1D, 1W)
- Closest lower Pivot Point
- Minimum of the current day
- Weekly support level
- Minimum of the current week
- Current Price – k* ATR (Average True Range show average price motion; k between 2 and 5)
Take Profit is the desired level of profit and must correlate with Stop Loss level. One of the most important indexes of the strategy is relation SL/TP. This relation is called risk/reward level of the strategy. (listed rules are for the Buy signal):
- Last Pick (Visual Pick of the price for the reasonable period)
- Closest upper Pivot Point
- Maximum of the last bar (Suitable for the high time frames, 4h, 1D, 1W)
- Current price + k*Standard Deviation (Standard Deviation indicator stands for an average price motion; k between 0.5 and 1)
- Current price + k*ATR (ATR – average true range, calculated on a different principal than Standard Deviation; k between 0.5 and 2)
Early exit rules
During manual trading, it is very useful to consider Early exit rules. With such rules trader will have a chance to determine if predicted scenario is no longer valid, then exit a trade in reasonable profit or minimal loss.
- Trailing stop. The size of the trailing stop depends on the timeframe and amplitude of the market noise. Reasonable trailing stops for different timeframes of the EURUSD: 30m – 20 points; 1H – 30 points; 4H – 80 points; 1D – 80 points; 1W – 300 points;
- After trade signal Stochastic goes back in overbought/oversold levels and price does not go in a predicted
This picture shows signals of the strategy. Note, that both %K and %D lines have to enter overbought/oversold zones. The crossing of this lines must also occur in these zones. Sometimes Stochastic gives false signals and stays in the zone after crossing the Signal line. If false signals occur too often – one should tune the Indicator inputs, firstly – make longer the period of the Signal line %D.
Next step is to choose Stop Loss and Take Profit for the trades. On this screenshot Stop Loss selected by the rule 4*ATR (ATR has period 14). Take Profit equal 2*ATR (ATR period 14).
On this screenshot Strategy gave four profitable signals and two signals were closed with Early exit rules.
Simple strategy; useful for intraday trading. Works well during ranging market.
Stochastic Oscillator strategy gives false signals during a strong trend.