While engaging in CFD trading, the use of momentum indicators is crucial because they enable traders to make decisions about whether to enter or exit a market at any given moment. One such momentum indicator is the Stochastic Oscillator, which you can utilize for making trade decisions. Although it may not be as popular as the RSI indicator, it might be equally useful and reliable, which is why several traders have been using it since its inception in the 1950s.
If you’re keen to learn more about the Stochastic Oscillator and how to incorporate it into your CFD trading strategy, this article is for you. In this article, we will delve into everything you need to know about the Stochastic Oscillator, including its benefits, how it works, its compatibility with other technical indicators, and much more. We even backtest the stochastic oscillator for the ETF that tracks S&P 500: SPY.
Understanding the Stochastic Oscillator
But before delving into the details, let’s first cover a few basics about this indicator.
What is an Oscillator?
An oscillator is a technical analysis tool that creates upper and lower bands within the spectrum of two extreme values, forming a trend indicator that fluctuates within these defined boundaries. This oscillating trend indicator is crucial for traders as it aids in identifying short-term instances of overbought or oversold conditions within the market, allowing for more informed trading decisions.
- Ultimate Oscillator Indicator Trading Strategy (Backtest)
- What does overbought mean?
- What does oversold mean?
What is the Stochastic Oscillator?
The Stochastic Oscillator is a specific type of oscillator widely used in technical analysis to pinpoint overbought and oversold conditions in the financial markets. This indicator, often attributed to George Lane, tracks the relationship between closing prices and the highs and lows observed over a predetermined number of days. See an example of it further down in the article.
To enhance its usability, the Stochastic Oscillator uses an averaging method to smooth out the results. George Lane, the creator of this tool, classified it as a momentum indicator, emphasizing its significance in assessing the market’s potential future direction based on current conditions.
Importance of the Stochastic Oscillator in Trading
Is the indicator useful? Let’s discuss:
Using the Stochastic Oscillator as a Technical Indicator
Using the Stochastic Oscillator as a Technical Indicator involves assessing recent stock strength and its trading performance relative to a specified lookback period. Unlike measuring the velocity of price movements, Stochastics focuses on how the current price compares to the high and low values observed over the preceding x days. If the current price is significantly lower in relation to the high/low range of recent days, the Stochastic reading is low, and conversely, if it’s closer to the high, the reading is high.
We would also like to remind you that Williams %R more or less is the same indicator.
Benefits of Using the Stochastic Oscillator
Some of the advantages of the Stochastic Oscillator include the following;
- Clear Entry/Exit Signals: The Stochastic Oscillator has a simple and intuitive design that generates distinct visual signals. When the oscillator reaches extreme levels, it becomes evident when it might be the right time to buy or sell a security. This clarity is especially useful for traders who want uncomplicated signals for their trading decisions.
- Frequent Signals: For traders who operate on shorter timeframes, such as intraday charts (e.g., 5, 10, or 15 minutes), the Stochastic Oscillator offers frequent signals. The stochastic Oscillator’s sensitivity to price movements in smaller ranges allows for more opportunities to enter or exit positions.
- Ease of Interpretation: The Stochastic Oscillator uses lines that fluctuate within a range of 0 to 100. These lines are relatively easy to understand, even for those new to technical analysis.
- Widespread Availability: The Stochastic Oscillator is readily available on most trading platforms, online brokerages, and technical charting services, allowing traders and investors to easily access and utilize it without the need for specialized software or platforms.
- Compatibility with Various Assets: The Stochastic Oscillator is versatile and can be applied to various financial instruments, stocks, currencies, commodities, and cryptocurrencies.
- Customizable Parameters: Many trading platforms and charting tools allow users to customize the parameters of the Stochastic Oscillator. Traders can adjust the lookback period, smoothing, and overbought/oversold levels to tailor the indicator to their specific trading strategy and preferences.
- Risk Management: The Stochastic Oscillator can aid in risk management by helping traders identify overbought or oversold conditions, which may indicate a need to adjust or exit positions.
Basics of Trading with Stochastic Oscillator
Let’s look at the basics of the stochastic indicator:
How to Calculate the Stochastic Oscillator
Below is an example of the indicator and how lit looks on a chart:
The Stochastic Oscillator comprises two lines: a fast line known as %K and a slow line called %D.
To calculate %K, you start by determining your lookback period, denoted as “x days.” For example, if you’re using a 4-day lookback period, the calculation can be expressed as follows:
This formula measures how the current closing price relates to the range between the lowest low and highest high observed over the last 4 trading days. It calculates the relative position of the closing price within this range and expresses it as a percentage.
%D is the slow line and is typically an average of the %K values. The specific number of days used for this average can vary depending on the trader’s preference. For instance, a common choice is a 3-day simple moving average of %K. The %D value is calculated by averaging the %K values over the selected number of days.
Interpreting Stochastic Oscillator Readings
The Stochastic Oscillator readings are essential for assessing the market conditions. Here’s how to interpret them:
Overbought and Oversold Conditions
The Stochastic Oscillator is used to identify overbought and oversold conditions in the market. When %K and %D values move above a certain threshold, typically 80, it suggests that the asset may be overbought, indicating a potential reversal or pullback. On the other hand, when these values drop below a threshold, often set at 20, it implies that the asset is oversold, signalling a possible buying opportunity.
Crossover signals are generated when %K crosses %D. A %K crossing above %D is considered a bullish signal, suggesting a potential upward price movement. On the other hand, a %K crossing below %D is a bearish signal, indicating a possible downward price movement.
Divergence occurs when the Stochastic Oscillator’s movements differ from the price trend. Bullish divergence happens when the oscillator makes higher lows while prices make lower lows, signalling a potential upward reversal. A bearish divergence occurs when the oscillator records lower highs while prices make higher highs, suggesting a potential downward reversal.
Best Practices for Using the Stochastic Oscillator
- Confirmation with Other Indicators: It’s often beneficial to confirm Stochastic signals with other technical indicators or chart patterns to reduce false signals and increase the reliability of your trading decisions.
- Adjust Parameters: Customize the lookback periods and smoothing methods to suit your trading strategy and the specific asset you are analyzing. Experiment with different settings to find what works best for your approach.
- Use Multiple Timeframes: Analyzing Stochastics on multiple timeframes can provide a broader perspective and help identify significant trend changes or reversals.
- Practice Risk Management: Overbought and oversold conditions are not guarantees of immediate price changes, so it’s essential to incorporate proper risk management in your trading strategy to protect your capital.
Advanced Stochastic Oscillator Strategies
Using Stochastic Oscillator in Trading CFDs
The Stochastic Oscillator is a crucial tool in CFD trading used to assess market conditions. It analyzes the relationship between the closing price and the recent price range, focusing on the %K and %D lines. CFD traders use these lines for signals in the following ways:
- %K crossing above %D can be seen as a buy signal when both lines are below 20%
- A sell signal when both %K and %D are above 80%.
However, it’s vital to confirm Stochastic signals with other indicators and analysis methods to ensure trading decisions are well-informed. But above all, it’s important to backtest. See further down in the article for a backtest.
3 Benefits of Trading CFDs with Stochastic Oscillators
- Precise Entry and Exit Points: One of the primary benefits of incorporating the Stochastic Oscillator into your CFD trading strategy is the ability to identify precise entry and exit points.
- Versatility Across Asset Classes: The Stochastic Oscillator is a versatile tool that can be applied to various asset classes beyond stocks.
- Risk Management and Confirmation: The Stochastic Oscillator not only provides signals but also plays a crucial role in risk management. It helps traders avoid impulsive decisions by encouraging the confirmation of signals with other technical indicators or analysis methods.
Step-by-Step Guide to Trading CFDs Using Stochastic Oscillator
These are the typical steps you will follow when using the Stochastic Oscillator in CFD trading;
- Select Your Trading Asset: Begin by selecting the asset you want to trade, whether it’s a stock, currency pair, commodity, or cryptocurrency. Ensure you have access to the relevant price data and charts.
- Set Up the Stochastic Oscillator: On your trading platform or charting software, add the Stochastic Oscillator indicator. Choose the lookback period that aligns with your trading strategy, considering both fast and slow Stochastic options.
- Identify Overbought and Oversold Conditions: Monitor the Stochastic Oscillator readings. When %K rises above 20%, it suggests the market is recovering from being oversold, potentially indicating a long-term position opportunity. On the other hand, when %K drops below 80%, it can be seen as a signal for a short position.
- Use Confirmation Tools: To enhance the reliability of Stochastic signals, employ confirmation tools, such as other technical indicators or chart patterns. Avoid trading solely based on Stochastic signals and set stop-loss orders to limit potential losses.
- Monitor the Market: Continuously monitor market conditions and the Stochastic Oscillator as your trade progresses. Be prepared to adjust your position or exit if conditions change or new signals emerge.
- Practice and Refine Your Strategy: Trading with the Stochastic Oscillator requires practice and refinement. Learn from your trades, adjust your strategy as needed, and strive for consistency in your trading decisions.
Combining Stochastic Oscillator with Other Technical Indicators
Relying on the Stochastic Oscillator alone may not be enough to accurately make trading decisions. That is why it is crucial to use other indicators alongside Stochastic Oscillator for more reliable decision-making. Here is how you can use Stochastic Oscillator with other technical indicators.
Enhancing Stochastic Oscillator Signals with Moving Averages
Moving averages are effective tools for smoothing price data and identifying trends. To enhance the Stochastic Oscillator’s signals, consider using a simple or exponential moving average alongside it. For instance, if the Stochastic Oscillator indicates a buy signal and the price is above the moving average, it reinforces the bullish setup.
Using Fibonacci Retracement Levels with Stochastic Oscillator
Fibonacci retracement levels are key for pinpointing potential support and resistance levels on price charts. To validate Stochastic signals, examine how they align with important Fibonacci levels. For instance, if the Stochastic Oscillator indicates overbought conditions coinciding with a major Fibonacci resistance level, it strengthens the case for a possible downward reversal.
On the other hand, when oversold conditions align with a significant Fibonacci support level, it may suggest a buying opportunity. These levels also assist in setting precise stop-loss and take-profit orders, enhancing risk management.
Developing a Profitable Stochastic Oscillator Trading Strategy
Identifying Overbought and Oversold Conditions
The Stochastic Oscillator is renowned for its ability to identify overbought and oversold conditions in the market. Traders can use the Stochastic Oscillator’s %K and %D lines to spot these conditions. Generally, readings above 80% signal overbought conditions and those below 20% suggest oversold conditions. This initial step helps traders pinpoint potential trade setups.
Setting Up Entry and Exit Points
To develop a profitable trading strategy, it’s essential to define clear entry and exit points based on Stochastic Oscillator signals:
- Entry Points: Consider entering a trade when the %K line crosses above the %D line, preferably when both lines are in the oversold region (below 20%). This crossover signifies a potential bullish reversal. Alternatively, for a short position, consider entering when the %K line crosses below the %D line, with both lines in the overbought region (above 80%).
- Exit Points: Traders often exit a long position when the %K line crosses below the %D line or moves above 80%, signalling potential overbought conditions. For a short position, consider exiting when the %K line crosses above the %D line or falls below 20%, indicating potential oversold conditions.
Implementing Risk Management Techniques
Here are some of the risk management techniques you can use
- Stop-Loss Orders: Set stop-loss orders at predefined price levels to limit potential losses in case the market moves against your trade. This might be important in CFD trading where you use leverage, but backtests reveal that they are mostly detrimental. The reason is simple: a stop loss forces you out at the most inconvenient time.
- Take-Profit Orders: Define take-profit orders to secure profits when the market moves in your favor. These orders should be strategically placed to capture a reasonable portion of potential gains.
- Position Sizing: Determine the appropriate size of your positions based on factors, including your account size and risk tolerance. Avoid overleveraging, which can lead to significant losses.
- Diversification: Spread your investments across different assets or markets to reduce risk.
- Continuous Monitoring: Stay vigilant and continuously monitor your positions. You should also always be ready to adjust stop-loss and take-profit levels as market conditions evolve.
Stochastic indicator backtest – can it work for CFD?
In our strategy shop, we have a stochastic indicator trading strategy (#39). When we backtest the strategy on SPY we get the following equity curve:
There are 450 trades and the average gain per trade is 0.66%.
Is the strategy viable for a CFD strategy? It might be, but it’s impossible to be certain due to leverage and different “commissions” (ie. spreads) for each respective broker.
This article has covered all the crucial information you need to know about the Stochastic oscillator and how it can be used in CFD trading. It is clear that using this indicator offers several benefits, including precise and easy-to-interpret entry and exit points, its applicability to a wide range of assets, and its ability to provide less frequent signals. We even provided you with a backtest to make you better evaluate if this is a good indicator (it is).
However, it is crucial to customize the parameters, such as the look-back period, based on your trading strategy. A shorter look-back period, such as 5 days, results in a more sensitive and reactive indicator, which may generate frequent signals, just like we did above. On the other hand, a longer look-back period, like 14 days, creates a smoother and slower indicator, which may offer fewer signals.