Stochastic Oscillator is one of the most powerful tools used by traders for technical analysis in Binary Options trading. The word Stochastic is derived from the ‘Stokhastikos’ – an ancient Greek word which in English translates to ‘take a guess’. In Binary Options, Stochastic is actually an oscillator. So, what is an oscillator? An oscillator is nothing but a visual representation of the price movements taking place in the market. An oscillator is always represented in form of a histogram or line chart just below the price chart (generally shown using Candlestick charts).
In Binary Options we generally make use of Stochastic crossovers to understand possible price reversals and hence, identify entry points. It is to be remembered that it is always better to use Stochastic Oscillator in conjunction with some other type of technical analysis indicator. Using Stochastic as a standalone strategy can lead to flawed conclusions. When used along with other indicators, Stochastic Oscillator can be used to determine the following:
Market Entry Points.
Support and Resistance.
We did not cover this tool in our options trading training course. We kept our discussion limited to RSI and MACD. The reason is that understanding Stochastic Oscillator becomes easy when one has a proper understanding of RSI and MACD as Stochastic Oscillator is similar to those two indicators. All three tools namely, RSI, MACD and Stochastic Oscillator are more geared towards determining the strength of the market direction or price direction.
A VERY IMPORTANT POINT TO REMEMBER IS THAT ‘OSCILLATORS WILL ALWAYS MOVE WITHIN A RANGE.‘
This range is 0 and 100 in case of our Stochastic tool. The oscillator will move in the direction of the price of the underlying asset. So, if the underlying asset’s price moves upwards, the oscillator moves upwards and if the price moves downwards, the oscillator moves downwards.
REMEMBER: Within a range, the oscillator may show erratic movements reaching negative or positive extremes but that may not mean a price reversal. Put in other words, in a Bear Market, the oscillator may climb all the way up to the bullish extreme and in a Bull Market, the oscillator may move all the way down to the bearish extreme. This will only suggest entry points but not a price reversal.
Birth of Stochastic Oscillator
George Lane, who was a trader in the Futures Market, created the Stochastic tool. One of the typical characteristics of the futures market is that traders need to work with very short time frames. So, Stochastic worked with short time frame. So, Stochastic Oscillator is good even for Binary Options market where traders can execute trades for a very time frame.
The Basic Assumption of Stochastic
Using Stochastic as a method of technical analysis stands on one basic assumption:
‘The closing price of an uptrend underlying asset will always be close to the top of the entire day’s range and similarly, the closing price of a downtrend underlying asset will always be close to the bottom of the entire day’s range.’
The Stochastic Indicator Explained
There will always be two lines used in Stochastic Indicator. One line is called %K and the other line is called %D.
%K actually measures the variations of closing prices of the underlying asset on a day to day basis. This means that this line is a representation of short term price movements and hence, it is very volatile in nature. Because of the extreme noise created by the bulls and the bears throughout the day, this line can lead to false entry signals.
%D on the other hand is referred to as a Signal Line because it filters out the noise giving a far more smoother version.
Unlike %K, %D is a slow moving line and %K often crosses over %D. So, %D is essentially a long term line showing long term price trend while %K shows the short term fluctuations that eventually give birth to long term trend.
The Mathematics of Stochastic Indicator
Let us use a few symbols to get an idea of how these %K and %D lines are derived from market price data.
CP = Closing Price for a particular day.
H5 = The highest high closing price attained by the underlying asset in last 5 days.
L5 = The lowest low closing price attained by the underlying asset in last 5 days.
%K = [(CP – L5) / (H5 – L5)] x100 (This is known as Fast Stochastic Oscillator)
In order to derive the %D we need a longer time frame and hence, we use three short time frames where each time frame consist of 5 days as used to derive %K.
Let us define a variable named ∑H.
∑H = (CP – L5) for one time frame of 5 days + (CP – L5) for another time frame of 5 days + (CP – L5) for third time frame of 5 days.
Similarly, let us define a variable named ∑L.
∑L = (H5 – L5) for one time frame of 5 days + (H5 – L5) for another time frame of 5 days + (H5 – L5) for third time frame of 5 days.
So, if these three short time frames (remember that these are back-to-back time frames) of 5 days are each represented by 1, 2 and 3,
∑H = (CP – L5)1 + (CP – L5)2 + (CP – L5)3
∑L = (H5 – L5)1 + (H5 – L5)2 + (H5 – L5)3
%D = [ ∑H / ∑L ] x 100 (This is known as Slow Stochastic Oscillator)
When the mathematical values of %K and %D are plotted against time, we get two different lines that keep oscillating between values 0 and 100.
There are two things to remember here:
- Detectable patterns are often created by %K but because of its volatile nature, the patterns can often be very difficult to read.
- Data is smoothed out by %D and hence, we get a far smoother signal line that is not only capable of providing its own signals but also works as a base line for %K to crossover and give strong entry signals.
Explaining the Range
We mentioned before that the Stochastic Oscillator moves within the range 0 and 100. Those two points are outer reaches of the oscillator. However, we are not really interested in 0 and 100. We are far more interested in two other extremes – 20 and 80. When the oscillator moves to 20 or below, it means a situation of overselling. This means that the underlying asset has been oversold and that the bulls will take over the bears. Similarly, when the oscillator moves to 80 or above, it means a situation of overbuying. This means that the underlying asset has been overbought and that the bears will take over the bulls.
Understanding Stochastic Crossover and Using it in Binary Options
The Long Crossover
We said that %D is the long run line or the signal line that can produce signals of its own. So, how does it happen? Let us take a look at the chart below:
The black line is the %D or slow moving Stochastic Oscillator line or the signal line. You will notice four crossover points indicated by blue circles in the chart. These are points A, B, C and D. Points A and B are on the outer range 80 while points C and D are on the lower range 20.
This is how the long crossover works:
When the %D line (in our example, the black line) crosses the overbought limit (80) from below (point A) and then reverses and again crosses the overbought limit and moves down below 80 (at point B), it signifies the onset of the bearish trend. So, in binary options market, you will be selling or in other words, go for Put option.
Similarly when %D or the black line crosses the oversold limit (20) from above (point C) and then reverses and again crosses the oversold limit and moves up above 20 (at point D), it signifies the onset of the bullish trend. So, in binary options market, you will be buying or in other words, go for Call option.
This Put or Call is called Long Put or Long Call because you will be opting for long term trades. %D cannot be used alone for short term trading. For that you will have to use %K along with %D and see where %K crosses over %D. This crossover is called Short Crossover. For utilizing Long Crossover, it is always a good idea to use longer time frames where %D can effectively filter out noise and give a smooth trend.
The Short Crossover
We just said that in Short Crossover, you will have to use both %K and %D. In Short Crossover, %K needs to cross %D. This can happen under two circumstances:
- %K crosses %D when %D is showing a downtrend.
- %K crosses %D when %D is showing an uptrend.
Now there are four possible scenarios that are explained below:
Scenario 1 – %D Showing Downtrend: %K crosses %D from up and then reverse and crosses %D again from below and moves above %D.
Because %K is actually reversing its path, traders may think of it as a possible uptrend but that is not true. %D is actually showing downtrend and hence, despite a reversal in %K, it is not a good entry point for Call option.
Scenario 2 – %D Showing Downtrend: %K crosses %D from below and then reverse and crosses %D again from above and moves below %D.
Because %K is showing a bearish reversal and since %D is also showing a downtrend, it is a good entry point for a Put option.
Scenario 3 – %D Showing Uptrend: %K crosses %D from up and then reverse and crosses %D again from below and moves above %D.
Because %K is showing a bullish reversal and since %D is also showing an uptrend, it is a good entry point for a Call option.
Scenario 4 – %D Showing Uptrend: %K crosses %D from below and then reverse and crosses %D again from above and moves below %D.
Because %K is showing a bearish reversal while %D is still showing a bullish trend or uptrend, using this as an entry point for Call option is never a good idea.
Here is an example of Short Crossover at work:
Remember: “%D always shows the long term price trend by removing all noise and is more stable and reliable as a signal line. So, when using Short Crossover, if the short oscillator, i.e. %K shows a reversal that is against the trend shown by %D, the signal is not sustainable and can lead to dramatic losses due to short term price spikes or price surges.”
Why is Stochastic Oscillator Crossover Good?
That’s because when used correctly after identifying the right trend, this indicator can provide very strong signals for market entry and exit points.
Weakness of Stochastic Oscillator Crossover
The primary weakness of this technical indicator is the time lag. Never ever will the oscillator show the exact price momentum at any given point in time. Because it uses historical price to determine price momentum, it will never take account of what’s going on in the market. This makes Short Crossover quite risky affair. This is the reason why it is said that if %K shows a reversal against the trend shown by %D, it is not a good entry point. Because there is a time lag, you must always use other indicators and tools along with Stochastic Oscillator to correctly determine the trend.
Best Time to Trade Using Stochastic Oscillator
The best time to use Stochastic Oscillator is when you can identify an asset that is range trading. In other words, you find well-defined support and resistance points. Identify such an asset and deploy the Stochastic Oscillator. Because the asset will be ranging, the %K and %D will actually be trending between 20 and 80. But, there will be times of breakouts when the asset price will break the support and resistance. This will be indicated by Stochastic Oscillators where you will see %K and %D breaking through the outer limits of 20 and 80. Wait for sometime and let the market corrections to take place. You will notice that the oscillators will rally back to their initial state. When that happens, you can open Call or Put if the oscillators rally back from 20 or 80 respectively. Make sure that you stay patient. If the market corrections are taking time, there is no reason why you should become impatient and open premature trades. This can lead to terrible losses. An example of trading using Stochastic Oscillator when an asset is ranging is shown below: