The Stochastic indicator is to be found at the oscillator category under the Indicators tab if using the Metatrader as platform for the technical analysis and it is one of the most well-known oscillators in the world.
There is virtually no trader in this world not to know what the Stochastic oscillator is and how to interpret it. The default settings of the oscillator are 80 level to the upside and 20 to the downside.
The Logic Behind Stochastic Oscillator
The indicator comes with two lines, one being called fast stochastic and the other one slow stochastic and the whole key is to look at the cross between the two, when the cross is happening, and see if the market is in the overbought or oversold territory. If it is, then that would be a nice place to go and buy put or call options. Much depends on the time frame the indicator is plotted, because the expiration date is the one that makes the difference between a profitable option and one that expires out of the money. Therefore, it makes no sense to look at the overbought area on the 5 min chart and then go and trade end of day or one week expiration date.
Stochastic Oscillator Advantages
One of the great advantages of the Stochastic indicator comes from the fact that it is visible and traders are looking to get the perfect striking price by waiting for the cross between the two lines the Stochastic indicator plots, basically the fast one and the slow one. However, there is a catch, as the cross is not to be interpreted correctly if it is being made between 20 and 80 levels and it is more valid if it is forming above 80 or below 20. This shows extreme levels and in the first case put option should be traded while call options are recommended in the second one.
Ways to Find Strike Price
Another way to find great strike prices for binary trading is to add an intermediary level that should act as a continuation pattern and that is the 50 level. So the thing to do is to edit the indicator and to add the 50 level. In a bullish trend, after Stochastic is jumping from the 20 level and below and breaks the 50 level, that should be the signal for entering a call option. In a bearish trend the opposite is true as well as breaking the 50 level to the downside should give us the striking price for a put option as well.
The stochastic oscillator is showing what all oscillators are showing, namely the overbought and oversold levels, like mentioned a bit earlier. If you’re using the Metatrader for your analysis, as the Metatrader is the most popular trading platform that can be used for free, then under the Indicators tab, look for the Oscillators category and choose the Stochastic indicator.
Stochastic Oscillator and Divergences
As any oscillator, the Stochastic indicator is going to be plotted on your screen below the price as this is how oscillators are being represented. Divergences can be used here as well and as always it is advisable to stay with the indicator and not with price as the indicator is taking into account more candles when levels are being plotted. For example, if the period is 14, the default one, it means the indicator is considering the last 14 candles and plots the value based on that information, while price is referring always to the last candle. That being said, bullish or bearish divergences can form and I would filter them as ignoring the ones that are forming below the 80 level as well as the ones that are forming above the 20. Consider only the ones that end below 20 and above 80 as it means price is in overbought or oversold areas and forming a divergence in the same time.
Needless to say that in a bullish divergence we should look for trading call options while a bearish divergence is always signaling put options. Like mentioned at the beginning of this article, the big advantage the Stochastic oscillator has comes from the fact that it is forming a cross (the fast line is crossing the slow one) and if the cross is in the oversold territory, namely below the 20 level, it is considered to be bullish, so call options are favored, while if the cross is forming above the 80 level it is considered to be bearish, so put options are favored.
This characteristic is making the Stochastic oscillator being visible and easy to understand and it is being favored by many traders. However, it doesn’t mean that it is 100% accurate as this is correct and is functioning only when ranges are forming. In other words, if you’re able to identify a range, then using Stochastic is recommended and sessions for range trading are the Asian one and last part of the North American session.
As usual when it comes to the expiration date, it should be set taking into account the time frame the oscillator is plotted.