How to determine the levels of overbought and oversold by using a stochastic oscillator

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How to determine the levels of overbought and oversold by using a stochastic oscillator

The stochastic oscillator is an indicator that is used in trading to determine levels of overbought and oversold. For a trader, this will mean the moment when it will be profitable for him to open and close his trading positions.

Like all other indicators, the stochastic oscillator helps to predict the trader how a certain asset will behave. Invented it was around 1950.

The operating principle of the stochastic oscillator

This indicator is designed to monitor the price momentum. According to the theory tested in practice, the price pulse reacts much better and changes its direction faster than the price itself. With this indicator, we can predict the point at which the trend will unfold. And tracking the trend in trading binary options will be one of the decisive factors.

The stochastic oscillator has a number of features. It itself is the ratio of the last closing price and the range of low and high values ​​for a specific period of time. The idea that underlies the stochastic oscillator – the closing of transactions on an uptrend will have prices higher than the closing of transactions for the previous period. If the trend is downward, the closing prices of deals will be lower than for the previous period.

On the chart, the stochastic oscillator is displayed by two horizontal lines and two moving averages.

– Fast moving average line has a default period of 3, slow – 13

– The stochastic oscillator can range from 0 to 100.

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– Overbought and oversold levels are 80% and 20% by default. They coincide with two horizontal lines.

Overbought will be an asset, the fast and slow moving average of which will be above the 80% level. Assets will be considered as assets with moving averages below 20%.

Do not blindly trust overbought and oversold, because they will not always point correctly to the opening of “Put” and “Call” positions. The asset can be a significant time in both zones, which can confuse many traders.

How to adjust the display of a stochastic oscillator?

It is quite easy to do this. All you need is in the “Indicators” section of the list to select the Stochastic Oscillator you need. Not all brokers have this tool in their arsenal. We recommend that you look at the IQ Option website.

Further in the tab click on the “Configure and apply” tab, if you want to use the indicator with the standard settings, then click the “Apply” button.

If you understand what you are doing and want to use your own settings, at your disposal will be at least periods in percentage terms, as well as levels of overbought and oversold. The indicator should appear under the schedule of prices of traded assets.

How to apply a stochastic oscillator in trading?

A stochastic oscillator, like other indicators, must give signals to the trader for profitable opening and closing of trade transactions. In addition, our indicator allows you to determine the levels of oversold and overbought. How to use this indicator correctly – read further in the article.

Indication of overbought and oversold

Identifying overbought

In fact, we will need to track the downward trend. In what cases will it occur?

– Fast and slow moving averages exceeded the overbought level

– When a rapid moving average crosses the slow one from below.

The second signal is considered to be one of the additional signals, which indicate that the trend will be downward. Below you can see how it can be seen on the chart of the trading platform IQ Option.

Identifying oversold

Here we are already talking about an uptrend. As in the case of overbought identification, oversold will have 2 signals – the primary and secondary.

– Fast and slow sliding intersect below the level of oversold, we can expect an uptrend.

– The rapid sliding crossed the slowest from above. This will be an additional signal that will indicate to us the expectation of an uptrend.

Let’s look visually, using the example of a binary option IQ Option taken from the trading platform.

Discrepancy pointing to the upcoming trend reversal

The discrepancy pulls an indication of a trend reversal. The indicator and the price begin to move in different directions, which can indicate both a reversal in the direction of the upward and downward trend.

As the discrepancy in practice looks, we can see on the example of the charts from the broker of binary options IQ Option.

Conclusion

If you have learned or already know how to use a stochastic oscillator, then for sure you have already performed your technical analysis more than once, much more effectively. A certain advantage of this indicator is its ability to use with other indicators in the trade of binary options. Do not forget to study well all possible consequences of using this indicator. A stochastic oscillator requires careful handling. It is almost impossible to master it in 1 session of trading. So learn to use it best on a demo account.

“General Risk Warning: Binary options trading carry a high level of risk and can result in the loss of all your funds.”

Stochastic Oscillator Indicator: How to Use in Your Trading

Different kinds of indicators have been developed to help us confirm the quality of a certain chart pattern or build our own buy and sell signals. If you are looking for a technical investment analysis tool that lets you determine where a trend might be ending, then stochastic oscillator is what you are looking for.

Here’s what you should know about stochastic oscillator.

What is Stochastic Oscillator?

Developed in the 1950s, the stochastic oscillator is a momentum indicator that measures the relationship between a closing price of the security to its price range over a given period of time.

Using the process of stochastic oscillator helps traders determine the best time when to buy or sell the security. It helps a trader predict price swing turning points by comparing the security’s closing price to its price range. This type of indicator uses support and resistance levels.

Stochastic Signals

There are a few main strategies you can use the stochastic oscillator to find solid trade signals in the market that include;

Trend Following

The trend is still valid as long as the stochastic keeps crossed in one direction.

Stick with the trend when stochastic is in the oversold/overbought area. Do not fight it.

Breakout Trading

If the stochastic suddenly accelerates in one direction and the two stochastic bands are widening, then it can determine the start of a new trend.

Trend Reversals

When a stochastic is changing direction and leaves the areas of where the overbought/oversold occurred it may indicate a new reversal.

You can also combine moving averages or trend-lines on the stochastic to confirm this as we will discuss in a moment.

Divergence

With every momentum indicator, divergence is important as it helps show potential trend reversals.

What Stochastic Settings Should be Used?

The 14-period can either be days, weeks, months, hours, or even an intraday time frame. The next one is a 3-day SMA default settings for the %D. The stochastic oscillator has two numbers (%K and %D) which is explained below.

What Markets are Stochastic Oscillator Used?

The best way to trade the stochastic oscillator is in a ranging market rather than a trending market. Trending markets require lagging indicators such as MACD (simple, weighted, exponential moving average are also in this category) as it will keep you in a trend as long as the trend remains intact.

Moving averages tend to flatten in a sideways market and offer no useful information, thus lagging indicators are deemed useless in a trading market.

Ranging markets are tricky to trade because despite using oscillators, there will still be an increased frequency of signals, both buy and sell. That is why the use of stochastic is best in a ranging market.

How to Use the Stochastic Oscillator in Your Trading?

Originally the use of the stochastic indicator was to follow the momentum of a price, however, its current use is to identify an overbought and oversold security. To determine if the security is overbought or oversold, the stochastic is scaled from 0 to 100.

As you can see from the image above, there are two lines referring to Overbought and Oversold. The blue line in the chart above is the %K line, and the orange line is your %D line.

The security is considered as overbought when the stochastic lines are above 80 (green line in the chart above). When the chart indicates that the security is overbought, it means that it is expensive or it is the best time to sell a security.

In contrast, if the stochastic lines are below 20 (red line in the chart above), it means that the security is oversold.

When the chart indicates that the security is oversold, it means that it is cheap and worth buying. You can calculate the stochastic oscillator by determining two numbers.

As shown above, the FIRST is a formula,
%K = 100 (C – L of N) / (H of N – L of N)

As mentioned before, 14-period is the default setting of stochastic oscillator, meaning that the value of N is 14 and 3 for the %D.

The SECOND factor,
%D which is a 3-period moving average of %K.

The formula for %D line is %D = 100 X H3 / L3. The numbers are then plotted on a graph side by side so that analysts may look for fluctuations between 0 and 100.

How to Use the Stochastic Oscillator with Price Action and other Indicators?

Stochastic Oscillator with Price action

The use of stochastic oscillator is best with price action when looking for support and resistance levels. To find those levels, you use the stochastic indicator as a guide and price action to tell us when the markets are either overbought or oversold at any given time using the one-hour chart and confirming it on the 4-hour chart.

As shown above in the 1-hour chart, we can see a swing low and a swing high. Notice that in the stochastic indicator that it is overbought. After that, we move to the 4-hour chart.

If the 1-hour and the 4-hour chart indicate that it is overbought, then that becomes a very high probability setup to trade.

Stochastic Oscillator with MACD

The MACD – Moving Average Convergence Divergence indicates price trends and direction, whilst the stochastic oscillator compares a stock’s closing price to its price range over a period of time.

This is what makes these two indicators work well together because stochastic compares a stock’s closing price to its price range over a certain period of time, while the MACD is the formation of two moving averages diverging from and converging with each other.

When using these two indicators, look for the bullish crossover to occur within two days of each other. The crossover typically occurs below the 50-line on the stochastic to get a longer price move.

Preferably you might want the histogram value to move higher than zero within the two days you placed your trade.

Stochastic Oscillator with RSI

The use of stochastic RSI in technical analysis is to provide a stochastic calculation to the Relative Strength Index (RSI).

In short, stochastic RSI indicator is an indicator of an indicator.

This indicator ranges between 0 and 1 which is then plotted as a line. Rather than standard price data, it is created by applying the formula of a stochastic oscillator to a set of RSI values.

The difference of using the stochastic RSI is that it improves sensitivity and generates a higher number of signals than the traditional indicator.

You can calculate stochastic RSI by using this formula.

StochRSI = (RSI – Lowest Low RSI) / (Highest High RSI – Lowest Low RSI)

The stochastic RSI doesn’t always look similar to the price, meaning it’s a derivative of price.

An indicator is considered as oversold when the value drops below 0.20, meaning that the RSI value is trading at the lower end of its range and that the short-term direction of the underlying security may be nearing a correction.

On the other hand, a reading above 0.80 indicates that the RSI may be reaching extreme levels and you can use it to signal a pullback in the underlying security.

Recap

The stochastic oscillator provides trade signals to let you know where the trend might be ending. You can use it in many different ways, such as overbought/oversold levels, divergences, and bull/bear trade setups.

Many traders often misinterpret the stochastic indicator and it is an indicator that need practice to perfect.

Using Stochastic Oscillator in Trading

The Stochastic Oscillator is a momentum-type indicator that determines overbought and oversold positions. In other words, it can provide a trader with information on when they could possibly enter or leave the market. The indicator is also used to predict future performance of the underlying asset. It was created and introduced by George C. Lane in the 1950s.

The Stochastic Oscillator on the IQ Option trading platform

How does it work?

According to Lane himself:

The indicator doesn’t follow price, it doesn’t follow volume or anything like that. It follows the speed or the momentum of price. As a rule, the momentum changes direction before price.

This indicator, therefore, can help traders predict trend reversal points, which is always of great importance in trading.

The Stochastic Oscillator returns the ratio between the last closing price and the high-low range during a set period of time. It is based on the premise that during the uptrends, prices will be above the previous period closing price . Alternatively, during the downtrends, prices will likely be below the previous closing price.

During the uptrend the SO is likely to stay above the green line

The oscillator consists of two horizontal and two moving average lines (the fast and the slow ones). The fast moving average line by default has a period of 3, while the slow MA has a period of 13. The oscillator ranges from 0 to 100. Both levels, by default set at 20% and 80% respectively, coincide with two horizontal lines.

When the fast and the slow moving averages remain above the 80% level, the asset is in the overbought zone. When both lines remain under the 20% level, the asset is in the oversold zone. It should be noted, however, that the decrease in prices is not necessarily a signal to buy, as securities can remain in the oversold zone for quite some time without leaving it. Similarly, an upward price rally does not always indicate an urge to open a “Buy” position. Securities can remain overbought for relatively long periods of time during a strong uptrend.

How to set up?

Setting up the Stochastic Oscillator indicator in the IQ Option platform is easy.

  • Click on the “Indicators” button in the bottom left corner of the trade room. Go to the “Popular” tab and the Stochastic Oscillator from the list of available options.
  • Go to the “Set up & Apply” tab and, if you want to use the indicator with standard parameters, simply click on the Apply button.

Or you can adjust the indicator to your liking, changing %K and %D periods and levels for higher accuracy (alternatively, more signals).

The indicator will appear in the bottom part of the screen, right below the price chart.

How to use it in trading?

The indicator’s main purpose is to reveal the overbought and oversold levels and give traders a hint on when to open a position. There are several ways to determine such cases with the help of the Stochastic Oscillator, of which the following two are the most commonly used.

1. Overbought and oversold levels

Sell signals

When both slow and fast moving averages are above the overbought level, the trend might be expected to become bearish. The fast MA crossing below the slow MA might be an additional signal of an upcoming downtrend.

Reversal of the SO moving average lines above the green light is an indication of a beginning downtrend

When both slow and fast moving averages are below the oversold level, the trend might be expected to turn bullish. The fast MA crossing above the slow MA might become an additional signal of an upcoming uptrend.

Reversal of the SO moving average lines below the red line is an indication of a beginning uptrend

2. Divergence

When the indicator and the price action start moving in different directions, it might be perceived as a signal of an upcoming trend reversal. Divergences might be both bullish and bearish, as well.

Divergence as a harbinger of a trend reversal

It should be noted, however, that as any other technical analysis tool, the Stochastic oscillator cannot be expected to provide accurate signals 100% of the time. From time to time it can — and will — provide false signals that should not be used as an invitation to open a corresponding position.

Conclusion

The Stochastic Oscillator is a useful and interesting technical analysis tool. For maximum efficiency, it can be combined with other momentum indicators and trend-following indicators. Caution may be needed when working with the indicator, as different levels do not necessarily correspond to an upcoming trend reversal.

NOTE: This article is not an investment advice. Any references to historical price movements or levels is informational and based on external analysis and we do not warranty that any such movements or levels are likely to reoccur in the future.
In accordance with European Securities and Markets Authority’s (ESMA) requirements, binary and digital options trading is only available to clients categorized as professional clients.

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