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
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)
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 as below:
%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:
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).