Stochastic Oscillator and its Buy and Sell Signals

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Video Transcript:

Hello, traders. Welcome to the sixth module of the advanced technical analysis course: oscillators. In this lesson, we’re going to teach you what the Stochastic Oscillator is, and how to look for setups using it. Now, the Stochastic Oscillator is a momentum indicator that signals overbought and oversold readings or conditions in the market. This indicator doesn’t follow price or volume; it follows the speed of price movements. This is what we call momentum. And, this is important because momentum changes direction before price does. So an overbought and oversold reading on the oscillator can give you a heads up whether price is about to change direction or not.

Stochastic Oscillator

Now, this is what the oscillator looks like on your chart. As you can see, the indicator oscillates between 0 and 100, and has two lines in it, a faster and slower line. When the Stochastic reads below 20, the conditions in the market are oversold. Oversold conditions means that a very strong bearish movement or a very strong bearish pressure has taken price into low price levels that are unsustainable. And, as you can see here, we have hit oversold readings in the oscillator at this slope.

When it reads above 80, the conditions are overbought; it is the same thing. Like in this case, the oscillator is above 80 and almost touching 100 at this height. And as you can see, this enormous bullish pressure has taken price to extreme levels that are unsustainable. So to clarify these, oversold and overbought are conditions of extreme price levels that are unsustainable and a correction in price is needed.

So, this is where we are going to use the Stochastic Oscillator. We are going to use it for entries and of course, we are going to use it to exit our trades. And, the setups we are going to be looking for on the Stochastic Oscillator are very simple. The first one is the bull sale. The Stochastic lines have crossed below 20 and are at a support level. We are in oversold territory. What we look for is a cross of the faster moving average above the slower moving average, or the faster line above the slower line. And, I move up both lines above the 20 level.

And, here is an example. This is the Aussie-US dollar forward chart, and as you can see, we have hit a low here at a very strong support level and the Stochastic Oscillator is below 20. When we have a cross-over above 20 and a cross of the faster line above the slower line, we can go long on this currency pair. Of course, the stop losses should always go above the previous slope because if it reverses and takes on the previous slope, we are still in a down hole and this support level has been taken out. Remember that this is important. The Stochastic Oscillator can remain overbought or oversold for a long period of time on very strong up trends or down trends.

Stochastic Oscillator Setups

This is not the case because price bounced and moved up to the 88.05 level. And when the Stochastic hits 80, we can exit our trade with a profit. The same is true for the bear sale. The Stochastic lines have crossed above 80 at a resistance level. We are in overbought territory. And, what we look for is a cross of the faster line below the slower line and a move of both lines below 80.

Now, here is an example. It is pretty clear that we have hit a very strong resistance level right here, and the Stochastic Oscillator shows overbought reading. This means that this bullish pressure has taken price to an unsustainable level and we are due for a correction. When the faster line crosses below the slower line and both lines crosses below 80, we have a short entry and of course, the stop losses should always go above the previous high. And in this case, when the Stochastic Oscillator dips below 20, we can exit our trade with a nice profit on an enormous risk to reward ratio sale.

Now, as you can see here, when the Stochastic Oscillator hits oversold levels and we exit our trade, we are exiting the trade at the bottom of the move because then, price move all the way up to the same resistance level. So, you are going to be using the Stochastic Oscillator for entries and you are going to be using it to exit your trades. And, if you are more of a longer time-frame trader, you are still going to be using these same systems for entries and for exits. And, if you’d like to hold your trades for much longer, well, if you are long for instance, like in this case, you can say “partial profit” here and just wait for a re-buy and a move higher. But, we do recommend that if are taking the trade, you should exit at the next extreme level using the same indicator as you used before, in this case, the Stochastic Oscillator.


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Adam is an experienced financial trader who writes about Forex trading, binary options, technical analysis and more.

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