I will be honest with you. I am a fan of Stochastic Oscillator. Although there is one stream of traders who say that Stoch-Osc is an outdated indicator, I still think that this is an interesting indicator. What reasons underlie my interest? For me, Stoch-Osc is one of the best indicators that can predict when prices will stop (either for a moment or so).
Some of my trader-friends don’t believe. They say that Stoch-Osc often gives false signals. I say, yes you can or otherwise, BIG NO. It all depends on how you determine the correct settings for your Stoch-Osc.
The first thing to understand… Definition?? Hmmm… yeah…likely.
First of all, where does the name Stochastic come from? Stochastic means that comes from chance and probabilities. Well, the chance is not very inviting for who wants to invest in the currency market, right?
For those who have done little probes, stochastic it reminds of things. A stochastic oscillation is a representation of the random variable evolution over time.
A large part of theoretical finance applied to the modeling of financial products (derivatives or not) is based on the study of stochastic oscillation since mathematicians and financiers try to describe the evolution of currency prices by a random walk.
The basic concept, “slow down before changes”
Stochastic oscillation of momentum composed of two curves. An oscillator, as its name suggests, oscillates between two values or around an axis. Our Stoch-Osc is bounded between 0 and 100. This means that it cannot exceed these values.
The momentum is by analogy with physics and mechanical inertia. When the price of action is moving, depending on the strength of the movement, it takes time for it to change.
Its inventor, George Lane (1921 – 2004) was a futures trader in Chicago. This indicator is sometimes called (though rare) Lane’s stochastic. George Lane had observed that a projectile shot in the air, before turning to fall, must first slow down.
The Stoch-Osc, therefore, helps the trader to determine when the momentum of the currency market price turns around and this makes it possible to anticipate the price reversal.
It identifies the possible reversals by analyzing the position of the fence in relation to the range of the session.
How to use Stoch-Osc? Over-bought / over-sold
Usually, we draw two horizontal lines on the Stoch-Osc :
- a line at 80
- a line at 20
When Stoch-Osc is above 80 the title is said to be overbought. This means that the bulls have been the winners for some time and that the value has benefited from an increase during the last sessions.
When the Stoch-Osc has a value lower than 20 it is said over-sold. The currency suffered a decline due to bearish activity.
Examples of Stoch-Osc Uses
On the graph above I represented signals generated by Stoch-Osc. These are classic signals.
On the left, a strong correction ends with a lateral drift. The Stoch-Osc makes the rase motte. In this case, we expect it to come out of the 25’s (or 20’s – I put the horizontal lines at 25, 50 and 75).
We then have a range of trading range after a small rally in which a sell signal could have been an opportunity to lighten the position. It’s hard to say whether to settle the position or not. The correction was weak and we went to a low level. An indicator like the S-Filter let us see the strength of the trend.
However, Stoch-Osc, which is rising just below 50 after the weak correction, may prompt us to return again.
The chartist analysis also indicates a broken triangle at the top (end of April).
The period of the trading range is a blessing for the trader.
On the right, I think there is a bullish setup. The last sell signal is a small correction and the resistance is broken. This is a triangle from which one comes out at the top.
As we can see, the use of Stoch-Osc s does not dispense with the use of chartism or other indicators. The most classic is to use the MACD with Stoch-Osc.
In (1) we did a short sale. The courses go down. We can ignore the purchase signals of the Stoch-Osc because the corrections are very small, a sign of a good downward trend.
In (2) we have a trading range that starts with a lateral drift. There we can exploit the signals.
The range support is finally broken down and we have a new bearish rally in (3). Note that in (1) and (3) Stoch-Osc remains stuck under 20%.
In (4) we have a new range. The indicator, however, is struggling to pass above 80, limiting opportunities to make gains. We will be careful in these cases.
Nevertheless, the range takes place in a low zone (after a good correction), so we will favor the long positions (we have a kind of cup not very clean: the courts are preparing to go up).
And we will have been right to do it. The resistance is broken. A bullish rally is started in (5). We will ignore sales signals. If we want to take profits on a part of the position they will give us the opportunity.
At the end of (5) the upward support is broken. This is where you have to close the position and/or take a short position.
Note: we could have averaged downward on the green arrows. It’s dangerous, but it pays when we are SAFE that we are not in a downtrend on the higher UT. But, I repeat, it is a dangerous game reserved for the craziest or most seasoned.
The trick is that all positions close positively as soon as prices rise a little. This involves the centroid of positions.