The Stochastic is an important and useful indicator. Here we will investigate some of the standard functions and look at some of its possibilities.
Essence of the Stochastic Oscillator
There's no point delving into the detail of the Stochastic formula here. You can find this information in the background information of the MT44 trading terminal. Even if you don't have this terminal you can still download it free of charge. You can obtain some useful information here so it's worth a read. You can compare the workings of the Stochastic Oscillator to that of a pendulum. It swings and changes with each price impulse. The stronger the market movement is the higher the oscillation amplitude is. At the end of the impulse (the push) the pendulum slows. It will then reverse and move back. As a rule, a correction occurs on the market at this time. Then the whole cycle repeats. All these movements strongly resemble a pendulum that swings from the center to edges. The features of the Stochastic Oscillator are that it has a center of 50 and edges of 100 and 0.
Formation of a Classical Overbought Stochastic Indicator Signal
- When the Stochastic Oscillator reaches its extreme value, you can expect the reverse. We can consider extreme values as 20 and 80.
- With the red (fast) line and blue (slow) line of the Stochastic Oscillator being crossed immediately prior to the indicator reverse the price will go with it. But it's rarely mentioned that you should wait for this reverse. Only when both the fast and the slow lines of the Stochastic Oscillator have reversed, can you consider the reverse to be reliable and confirmed. You should then close the bar that formed the reverse.
- When the bar that confirms the reverse of the slow line has closed, a position can be opened after it.
- If the reverse takes place in the area of 20, a buy signal has been received
- If the reverse takes place in the area of 80, a sell signal has been received
The Most Important Overbought Stochastic Indicator Signals ' Divergences
Divergences or convergences are the most important overbought stochastic indicator signals. This is simple and shouldn't frighten you. A divergence is when peaks or lows diverge with price peaks and lows.
This will happen upon a new price low not being confirmed by a new indicator low. The red lines on the picture show the divergence. When the bulls take up the running, we see a significant correction that lasted month and a half.
It is clearly seen on the picture how this long correction ended because of a bearish divergence. There is a continuation of a down trend.
There is also such a thing as reverse divergence. Textbooks rarely cover this. That aside, this is a firm signal that there is a continuity to the trend. It is easy to recognize it. A trend can be seen in the picture. There is the formation of a small correction. Simultaneously, there is a large movement by the Stochastic Oscillator and once the maximum value of 80 is reached, the previous peak is exceeded. This will be the start of a strong and swift trend. Reverse divergence can also feature bullish and bearish. The bearish reverse divergence is shown on the picture. If a new price low on the ascending market is higher than the previous one and a new Stochastic Oscillator low is lower than the previous one, we will see the bullish reverse divergence
Where there is a divergence on indicator peaks and price, this is a short divergence.
As a rule, this type of divergence indicates a change of mood and at the least leads to a strong correction and even trend change. Yet, this signal is weaker than the previously mentioned divergence types. Normally, short divergences are classical divergences (bearish, bullish) but using a smaller timeframe.
Overbought indicators of a hidden divergence will not show any divergence! I.e. the is confirmation of a price peak by an indicator peak. But you can't compare their sizes. To give an example, price impulses are significant however even with the indicator peak showing as higher than the one earlier, it does not look significant in comparison to price peaks.
You can only rely on a Stochastic Oscillator signal when it has been confirmed. I.e., the bar that forms the reverse should be closed. It is also important to take into account that it is inadmissible to use only the signals of the Stochastic Oscillator. The signals of at least two signals should be used to confirm its signals. You could other types of overbought indicators like Momentum, OsMa, RSI or MACD. The indicators are standard in MT4 4.
You will have a correct prediction probability of around 60% - 70% from formed and confirmed divergences. Once the divergence has been formed on the border of a triangle or significant channel level, this likelihood increases to 75% - 80%.
A position can be exited using the reverse divergence. For instance, the bullish divergence on the trend that is descending. We have a useful method that we developed that we want to share with you. It is for a correct exit from a position on a divergence. It's an important moment and a question that's often asked. Miss it and you could lose your profit or even make a loss. The market should be entered on a triple divergence upon the border of figure and use the double divergence with no levels to exit. The rules of exit:: The levels of the previous peak are overcome by price on the chart.. At the same time, indicators are still below the level of the previous peak. A classical bearish divergence will occur if the price goes down. Chart peaks won't confirm the peak of the price so the correct price behavior can be predicted. Be ready to exit and prepare stops. Should no reverse occur and the existing bar closes and the divergence is disabled, you should put the stops back and continue with your trades.
Overbought Stochastic indicator signals are very valuable and quite accurate. But confirmation is needed and a significant level.
Good luck with your profits!