Using the stochastic oscillator in trading

Antreas Themistokleous

Trading Specialist at AthenaAvo

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This is not investment advice. Past performance is not an indication of future results. Your capital is at risk, please trade responsibly.

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In this guide:

  1. Understanding the stochastic oscillator: A key trading tool
  2. How to apply the stochastic oscillator in commodities trading
  3. Pros and cons of the stochastic oscillator
  4. Real-world application and case study
  5. Making the most of the stochastic oscillator
  6. Using the stochastic oscillator indicator on your AthenaAvo account

If you're familiar with the stochastic oscillator and are interested in commodities trading, then keep reading. Discover the components and the power of using this technical tool to identify areas of possible trade opportunities and boost your trading strategy.

Commodities trading can offer you a unique avenue to capitalize on the price fluctuations of different commodities like gold, silver and natural gas amongst others. In such a volatile and complex market, there are several tools and techniques you can use to navigate these fluctuations. One such tool that has gained widespread recognition is the stochastic oscillator. In this article we provide an in-depth exploration of this technical indicator and its various applications in commodities trading.

Understanding the stochastic oscillator: A key trading tool

Conceived by George C. Lane in the late 1950s, the stochastic oscillator is a momentum-based technical indicator that helps measure the speed and direction of price movements. This is accomplished by comparing the current price of a commodity to its price range over a specified period of time. The stochastic oscillator includes two main lines: %K and %D. The %K line shows the recent closing price compared to the price range, and the %D line, typically a moving average of %K, provides a smoothed view of its fluctuation.

The stochastic oscillator works on the principle that during rising price trends, prices usually close near the high end of the price range, showing a strong buying momentum. On the other hand, in a downward trending market, closing prices tend to be closing near the low end of the trading range, signaling increased selling pressure.

Components and calculations

To fully understand how this technical indicator works, it is important to study its two main components:

The %K Line is the main component, or raw value, of the oscillator. It is calculated using this stochastic oscillator formula:

%K = ((Current Close - Lowest Low) / (Highest High - Lowest Low)) * 100

Here, "Lowest Low" and "Highest High" represent the lowest price and highest price in a chosen timeframe.

The %D Line is a more refined version of the %K line. It appears as a smoothed out version, commonly in the form of a moving average of %K over a certain number of periods. This helps reduce noise and makes the overall price trend easier to see.

This chart shows crossovers of the stochastic oscillator

This chart shows crossovers of the stochastic oscillator.

How to apply the stochastic oscillator in commodities trading

This momentum indicator is an invaluable tool in commodities trading. Using it as part of your trading strategy can offer you a wealth of insights, potentially predicting trend reversals, overbought or oversold conditions, and the overall trend influencing a commodity's price. Let’s explore its various uses:

Application no.1: Identifying trend reversals

The stochastic oscillator is also really useful at helping you identify potential changes in trends – also known as trend reversals. If the %K line crosses over the %D line, and both lines are below the oversold point (e.g., 20), it suggests a possible shift from a downtrend to an uptrend. On the other hand, if the %K level line goes under the %D line, with both lines above the overbought point (e.g., 80), this could signify a shift from an uptrend to a downtrend.

Application no.2: Identifying overbought and oversold conditions

A key feature of the stochastic oscillator is its ability to identify overbought and oversold conditions. The signal happens when the %K line crosses the %D line, pushing it into the overbought area (typically going over 80). This occurrence suggests a possible correction or reversal in price. On the other hand, when the %K level line crosses below the %D line, falling into the oversold area (usually going below 20), it suggests a good time for potential buying, as the commodity could be undervalued.

Additionally, traders often capitalize on the difference between price and the stochastic oscillator. For example, if a commodity's price shows higher highs while the stochastic oscillator shows lower highs, this difference might indicate a possible price change.

Application no.3: Pairing it with other indicators

The stochastic oscillator is a useful tool on its own, but it’s even more useful when you combine it with another technical indicator. You may want to try pairing it with a trend-following indicator such as a period moving average, a 3 period moving average, or the relative strength index (RSI) to confirm a buy and sell signal and improve trading accuracy.

Application no.4: Choosing the right timeframe

Getting the most out of this momentum indicator depends on how carefully you choose the period of time for its calculations. Shorter timeframes (such as 5-day or 14-day) offer more frequent signals, but these may not be as reliable as longer periods. On the other hand, longer timeframes (such as 50-day) yield stronger buy and sell signals but might be slow to catch up with fast-changing price trends. Trying out different timeframes and adjusting your strategies accordingly might help you decide which one suits your trading objective and risk tolerance level.

Pros and cons of the stochastic oscillator

Many traders have been debating how useful and effective stochastic oscillators are in various trading strategies but what exactly is true? Here is a short list of advantages and disadvantages of this technical tool to help you decide:

Pros

  • Functions as a momentum indicator helping you identify overbought and oversold levels
  • It is relatively easy to use and interpret
  • Useful for identifying a potential trend reversal
  • Serves as a versatile tool, adaptable to a variety of trading strategies
  • Identifies trading opportunities in both trending and ranging markets

Cons

  • As a lagging indicator, it may not immediately reflect price movements
  • In trending markets it can be ‘noisy’ offering incorrect signals due to rapid price movements
  • It merely confirms trends that are already evident
  • Not as reliable as other indicators that help measure momentum, such as the relative strength index (RSI)
  • It can be challenging to use effectively on volatile instruments

Real-world application and case study

To clearly show how useful the stochastic oscillator is in trading commodities, let’s look at a hypothetical case involving the trading of gold.

Case study: gold trading

Imagine you are a commodities trader trading gold CFDs. You notice a constant decrease in gold prices over several weeks, causing worries of a long-term price decline. Eager to identify potential points where the trend changes direction, you start using the stochastic oscillator for your technical analysis.

Applying the stochastic oscillator

After carefully researching and studying historical price data, you choose a 14-day time period to calculate the stochastic. Upon analysis, you observe the %K line moving above the %D line, with both lines sitting under the oversold limit of 20. This meeting of the stochastic lines suggests that gold might be about to become oversold, which means there could be a price reversal coming soon.

Combining the stochastic oscillator with other technical tools

To make sure this signal is reliable, you can look at another often used technical indicator, such as a moving average and trendlines. Additionally, the moving average convergence divergence (MACD) indicator shows signs of potential bullish divergence. This increases the chances of predicting or identifying a reversal.

Equipped with the signals from the stochastic oscillator, MACD, and additional technical tools, you take the calculated decision to open a long position on gold. Your next trading sessions prove that this was a good decision, since the price of gold does indeed turn around and start to go up.

This case study shows the important role the stochastic oscillator plays in guiding the decision-making process and identifying a nearing trend reversal, which ultimately led to a profitable trade.

Frequently asked questions

The stochastic oscillator can help you identify overbought or oversold asset prices. When the level on the stochastic moves above 80, the asset is usually overbought. If it’s below 20, then it’s typically oversold. As a rule of thumb traders tend to use these areas as potential levels on the charts to initiate buy or sell trades. As with anything in trading, you cannot rely on a single trading tool to make financial decisions. It is wiser to use this tool in combination with other tools to make the most informed decisions for each trade.

The relative strength index (RSI) and stochastic oscillator are both widely used momentum oscillators that help identify overbought and oversold market conditions in the market. RSI compares recent gains and losses to evaluate the magnitude of a price movement, while the stochastic oscillator compares closing prices to confirm the trend. RSI is more effective in trending markets, while the stochastic is more useful in sideways or choppy markets. So it’s not a question of the ‘best’ tool to use, but rather which is better depending on the trend of the security at any given time.

While the stochastic oscillator is useful, it's not the only tool to rely on since it can sometimes produce false signals. It’s better to pair it with an alternative indicator like moving average crossovers (short-term above long-term) to confirm trends. You can also use the relative strength index (RSI) and moving average convergence divergence (MACD) to support the stochastic oscillator. RSI looks at price movement speed, while MACD tracks price momentum shifts.

Making the most of the stochastic oscillator

In order to succeed in trading commodities, you need to have a good understanding of technical analysis. The stochastic oscillator is a key tool that can help you navigate the commodities market confidently. By using this tool to identify overbought and oversold conditions, and confirm signals from a different indicator, you can elevate your decision-making and potentially improve your trading outcomes.

But like any tool, this indicator isn’t perfect. It requires a combination of skill, experience, and risk management to yield consistent results. As with any trading strategy, it’s wise to thoroughly test the stochastic oscillator and adjust it to your unique trading style before putting real money into it.

As shown in the case study for gold, stochastic oscillators have proved themselves to be practical and potentially lucrative. If you have a good grasp of its characteristics and mechanics you can leverage its power to make wise decisions in the exciting and ever-evolving world of commodities trading. By incorporating it into a comprehensive trading strategy, you can work towards reaching your financial goals while carefully managing risks.

Using the stochastic oscillator indicator on your AthenaAvo account

Ready to elevate your commodities trading strategy with the power of stochastic analysis? Join AthenaAvo today and make informed trading decisions with confidence. Take advantage of our cutting-edge tools and superior trading environment to optimize your trading potential. Don't miss out on this opportunity to explore the markets with precision – sign up now and start trading commodities with the broker that professionals trust.

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This is not investment advice. Past performance is not an indication of future results. Your capital is at risk, please trade responsibly.