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Stochastic Oscillator

A large number of trading signals does not necessarily mean more profits in binary options trading. Some of the signals are false when the workout is made in a sideways range or it’s too short to make a decent profit. Stochastic Oscillator Strategy was developed to solve the issue of fake breakouts, filter the market noise, lower the number of trading signals and increase their efficiency.

Let’s find out how the technical analysis can help binary options in that task.


Technical indicators based on measuring market waves - oscillators - became very popular as they show several layers of information needed for a binary options trader to make profitable trading decisions on a daily basis. It is well-known that financial markets always move like waves in terms of up- and down-swings, even during strong trends happen retracements or consolidations when CALL or PUT options buyers take a breather to rebalance the supply-demand ratio. Oscillators were created to measure those waves and reflect them in a visual representation so traders could make decisions at first glance on a price chart.

What is a Stochastic oscillator?


Stochastic was one of the first oscillators ever developed in the technical analysis. It has a simple mathematical formula comparing the relative momentum or strength of a trend to the price range between the lowest and highest prices within the given period. The oscillator also has overbought and oversold levels, the position of which in the indicator’s window can be adjusted depending on how frequently traders want to get signals. It consists of two lines ranging between 0 and 100. Binary options traders can apply an additional smoothing of the oscillator by enlarging the calculation period or by applying a moving average of the result.

Here is how the Stochastic Oscillator looks like on a price chart:

Stochastic Oscillator

Stochastic oscillator formula


The formula is as follows:

Stochastic %K = [ (Close - Low N) / (High N - Low N)] / 100,

%D = simple moving average of %K in 3 periods

where:

Stochastic %K is the current value of the stochastic oscillator (blue line),

%D is - close is the most recent close price,

Low N - is the lowest price in N periods, typically 14 bars,

High N - is the highest price in N periods.

Stochastic oscillator settings


An important factor to adjust indicator’s sensitivity is to change the default parameters of the formula. Best stochastic oscillator settings can be selected depending on a personal trading strategy, the frequency of entries, a particular asset class and so on.

Default parameters in Stochastics are as follows:

  • %K period - 14 bars (hours or days, depending on the timeframe);
  • %D period - 3 bars;
  • Smoothing - 3 bars;
  • Overbought level - 80;
  • Oversold level - 20.

The main period influences the mathematical formula and determines how many periods should be taken for the calculation of the blue line. This is the key factor impacting the indicator’s sensitivity. If a trader enlarged the period, then the oscillator would get a more smoothed shape, and the number of bounces towards extreme values will be lower. Such a choice is suitable for long-term traders interested to catch strong price action, while short-term and insignificant fluctuations are ignored. When reducing the period, the indicator would start waving much more frequently, sending more trading signals. This selection might be attractive for short-term traders with many deals to open in the same period. Lowering the oscillator's period would lead to a larger number of false signals though.

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Other settings are not so important and it would be better to leave them as default. %D period points to how many periods are used for the simple moving average of the %K line. Too many periods would cut peaks and bottoms of the value, while a lower period would not reach the necessary effect of the moving average. The widest range of this parameter is from 3 to 9 bars. Smoothing period is also good enough for any applications. Shifting overbought and oversold levels would enlarge or lower the overall number of trading signals. Again, default settings reflect the market conditions in the best way.

How to use stochastic oscillator?


The main advantage of a stochastics indicator is that it shows the current momentum. In other words, the oscillator measures the strength of the recent price action compared to the previous action in the chosen period. From a trading point of view, analysts find periods when stochastic lines are coming out of the oversold (bullish reversal) and overbought (bearish conditions) levels. This means that the bears or the bulls start losing power to move prices in the previous direction and the trend starts in the opposite direction. One more important event happening at that time is that both lines of the oscillator cross each other, preferably in the oversold or overbought zone. The crossover means that recent prices are changing faster than the moving average of the Stochastic %K value, shifting the technical sentiment.

This is a perfect reversal signal:

Stochastic Oscillator

Stochastics oscillator have a disadvantage, like any other sensitive indicators based on measuring waves. The problem is that a reversal trading signal does not necessarily mean a complete trend reversal. If a short-term rebound or a sideways consolidation happens after an uptrend peaked, for example, the lines of the indicator could start sliding but the following price action is insignificant. Rates could just hover in a tight range or a short-term plunge is charted, but the trading does not bring the wished result in terms of a sustainable counter-trend. This is why a second layer is added to the equation.

What is slow and fast stochastic oscillator


The main idea is to combine two oscillators with different periods. The first indicator is the fast stochastic oscillator with periods 8, 5, 3. The main goal for such a sensitive indicator is to provide preliminary or initial trading signals. Binary options do not take the trade immediately after the fast stochastic offers an opportunity but start monitoring an additional instrument. The second indicator in the combination is the slow stochastic oscillator with settings 17, 7, 3. It works as a confirmation tool after the fast indicator provides a preliminary signal. As a result, traders do not start entering the market too early, the market conditions get an additional smoothing, the unnecessary noise is cut out of the equation and the overall effectiveness of the trading system increases.

Examples of using


This section is aimed to provide several examples of how trading binary options can be profitable using the double stochastic combination in the technical analysis.

Buying PUT options for USD/CAD after an uptrend reversed


The daily chart below shows the USD/CAD currency pair in a long-term uptrend. An initial reversal signal came in from the fast oscillator as its lines performed the bearish crossover in overbought territory. However, the uptrend continued for two more days before the bears stepped in with heavy-volume demand for PUT options. The slow stochastic signalled the beginning of a new downtrend when its lines went off the overbought zone. As the price chart shows, the trading cycle of buying PUT options was profitable until an opposite signal occurred.

Stochastic Oscillator

Buying CALL options for USD/JPY after an intraday rebound


The four-hourly chart below points to a strong reversal signal after USD/JPY bottomed out on October 31, 2019. The fast stochastic had a preliminary signal, showing a bullish crossover in the oversold zone. However, the confirmation came only two candles after that (8 hours). The trading cycle of buying CALL options was lucrative as 81.25% of the deals were in the money. The cycle was stopped when both oscillators had an opposite signal, pointing to a bearish reversal.

Stochastic Oscillator

Conclusion


The stochastic oscillator is a widely used technical instrument to measure the market momentum and show overbought and oversold levels. Two lines represent an additional smoothing, allowing traders to find reversal points and profitable trading signals. However, several market conditions lead to a short-term rebound or a sideways range without a new sustainable trend. Stochastics are sensitive so some of the signals are false. Binary options traders developed a Double Stochastic trading strategy to filter the market noise, increase the efficiency of trading signals and enter the market in time, exactly when the reversal price action begins.


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