Reprinted from: http://www.alpari.co.uk/en/market-analysis-guide/technical-analysis/stochastic.html

Oscillators: Stochastic Oscillator

The aim of the Stochastic Oscillator is to determine price behaviour and reversals by monitoring close prices within the recent highs and lows. The method is based on the observation that when prices are rising their close levels tend to be closer to the top. If the quotes tend to move downwards, the close is usually near the bottom.

Stochastic Oscillator consists of two %K and %D lines calculated as follows:

%K = (CLOSE - MIN (LOW (%K))) / (MAX (HIGH (%K)) - MIN (LOW (%K))) * 100

Where:

• CLOSE � current close price;
• MIN (LOW (%K)) � the lowest bottom within the number of %K periods;
• MAX (HIGH (%K)) � the highest top within the number of %K periods.
  

%D = MA (%K, N)

Where:

• N � smoothing period;
• MA � moving average.

To add Stochastic indicator in MetaTrader 4 use the "Insert -> Indicators -> Oscillators -> Stochastic Oscillator� menu sequence. The window with the settings will appear:

Stochastic Oscillator Settings

• %K period - number of bars used for Stochastic Oscillator calculation,
• Slowdown - the degree of %K line inner smoothing. Value 1 gives a quick Stochastic Oscillator and value 3 � a slow one,
• %D period - the moving average period along the %K line. It is used for %D calculation,
• MA method - the %K line smoothing method (exponential, simple, smoothed, linear weighted) used for %D calculation.

Once the Stochastic Oscillator parameters have been set and the OK button has been pressed, the indicator appears under the price chart:

Stochastic Oscillator analysis

The %K line is usually displayed as a solid line and %D as a dashed line. At the level of 80% and 20% the overbought areas (higher than 80%) and oversold areas (lower than 20%) are indicated. Stochastic signals from these areas are considered to be more significant.

These are several basics of the Stochastic Oscillator analysis:

• Bullish divergence / bearish convergence is the main signal that shows that the current trend is weak;
• If the solid line (%K) crosses the dashed line (%D) from below this is a signal to buy; if the solid line (%K) crosses the dashed line (%D) from above this is a signal to sell;
• Two sequential opposite intersections of %K and %D lines mean that the first signal was premature and that the previous, stronger price movement may resume;
• If both lines move in the same direction then they move in the trend direction;
• In a flat market, exit from the overbought (oversold) area is a signal to sell (to buy).

Stochastics

Stochastics

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Stochastics

Stochastics are another indicator that helps us determine where a trend might be ending. By definition, a stochastic is an oscillator that measures overbought and oversold conditions in the market. The 2 lines are similar to the MACD lines in the sense that one line is faster than the other.

How to Apply Stochastics

Like I said earlier, stochastics tells us when the market is overbought or oversold. Stochastics are scaled from 0 to 100. When the stochastic lines are above 70 (the red dotted line in the chart above), then it means the market is overbought. When the stochastic lines are below 30 (the blue dotted line), then it means that the market is oversold. As a rule of thumb, we buy when the market is oversold, and we sell when the market is overbought.

Looking at the chart above, you can see that the stochastics has been showing overbought conditions for quite some time. Based upon this information, can you guess where the price might go?

If you said the price would drop, then you are absolutely correct! Because the market was overbought for such a long period of time, a reversal was bound to happen.

That is the basics of stochastics. Many traders use stochastics in different ways, but the main purpose of the indicator is to show us where the market is overbought and oversold. Over time, you will learn to use stochastics to fit your own personal trading style.

Use Stochastics in Trending market
The key is when the market is trending up, we will look for oversold conditions (when the Stochastics fall below the oversold level (below 20) and rises back above the same level) to get ready to trade, and in the same way, when the market is trending down we will only look for overbought conditions (when the Stochastics rise above de overbought level (above 80) and falls back below the same level.

Use Stochastic in Trend-less market

Buy when %K falls below the oversold level (below 20) and rises back above the same level.

Sell when %K rises above de overbought level (above 80) and falls back below the same level.