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Trading a Range Bound Market with Stochastic Oscillator

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74-89% of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

If old is gold, as the expression goes, then the Stochastic Oscillator is one of those old school technical analysis tools that has aged well over the last six decades. The Stochastic Oscillator was developed in the early 1950's by George C. Lane as an oscillator, which means you can use it to gauge the momentum in the market accurately.

Stochastic Oscillator measures the price momentum, as well as the directional movement of the price, by displaying the location of the closing price in relation to the high-low range of the asset over a predefined number of time periods. As a result, when most indicators show the direction of the price, Stochastic Oscillator demonstrates the speed of the price. Since the momentum of the asset price changes before the actual price, you can use the Stochastic Oscillator as a leading indicator to predict any impending change in the direction of the price.

While most beginner traders use Stochastic Oscillator during trending markets to find divergence and trend continuation signs, one of the best-hidden secrets of this tool is its ability to indicate reversals near the upper and lower end of a trading range.

Stochastic Oscillator Works Great During Ranging Market

Before you endeavor to use to Stochastic Oscillator during a range bound market, you should know how to apply the indicator correctly and how you should interpret the indicator readings. Most popular trading platforms include the Stochastic Oscillator as part of the software package, and you can usually find under common oscillators. In MetaTrader 4, you can find it under the top menu >Insert Indicators > Oscillators.

Once you have applied the Stochastic Oscillator on a black price chart, it should add the indicator at the bottom of the window and show a reading of 0 to 100. In addition, you may also find two predefined levels added to the chart, the 20 and 80 levels. However, if your charting software does not add these two levels, please manually add these to your chart.

stochastic overbought oversold

Figure 1: Stochastic Oscillator Showing Overbought and Oversold Levels

As you can see in figure 1, when the Stochastic Oscillator reading goes below level 20, you should interpret the market as oversold. On the other hand, when the Stochastic Oscillator reading goes above level 80, you should consider the market as overbought.

However, most beginner traders often discount the strength of the trend and blindly try to countertrade the market when the Stochastic Oscillator becomes overbought or oversold. Hence, during a strong trend, they experience significant drawdowns and often give up using this great indicator.

During a trending market, you should be very cautious take the overbought and oversold market conditions at face value. However, the Stochastic Oscillator can offer traders a pretty reliable overbought and oversold levels during a range bound market.

Around 70% of the time the markets remain range bound. Therefore, the Stochastic Oscillator can help you trade such market conditions on a regular basis instead of waiting for those brief trends.

Trading with Stochastic Oscillator During Ranging Market

stochastic ranging market

Figure 2: Trading Ranging Market with Stochastic Oscillator

When most novice traders think of a trading range, they think about a horizontal price action. However, professional traders know that a range can form with an upward or downward slope as well. Hence, the first thing you should do is try drawing a channel around the range to identify the nature of the range. As shown in figure 2, you can use an equidistant channel to find out if the range has an upward or downward slope.

Secondly, you should try to find out if the Stochastic Oscillator is mimicking the price action slope by drawing a trendline around the lows during an upward sloping range or around the highs during a downward sloping range.

Once you have completed these two steps, trading any range bound market with the Stochastic Oscillator would be a straightforward affair.

As you can see in figure 2, when the price came near the bottom of the range, and the Stochastic Oscillator reading moved in proportion to the price action, both the price and Stochastic reading abide by their respective trend lines. When you find the asset price and Stochastic Oscillator are moving in sync like this, you can be pretty sure that the asset price will not likely going to penetrate the trading range, unless something extraordinary happens.

Here, you could just place a market order to go long near the bottom of the range or wait for a price action pattern, such as a pin bar or outside bar, to trigger your market entry. However, you can see in point 3, when the bullish momentum accelerated, the Stochastic Oscillator created a bullish divergence, where the indicator reading came down way too fast compared to the price in the range. In fact, on this occasion, the price stayed above the range when the Stochastic Oscillator fell towards the 20 level, indicating an oversold market condition.

When you find such huge divergence in the market, you can interpret this signal as a trend continuation confirmation and trade in the direction of the prevailing trend.

Conclusion

Trading price ranges can be extremely profitable if you know how to apply and read Stochastic Oscillator. However, you should never try to outsmart the market and go against the slope of the range, unless the range is pretty flat or horizontal.

So, keep in mind that during an upward sloping range, you should always look for opportunities to buy at the bottom of the range based on the Stochastic Oscillator signal, as we did in the example trades. On the other hand, when you are trading a downward sloping range, you should only look to find opportunities to sell.

Once you master the art of reading the Stochastic Oscillator in relation to price action, trading ranges could turn out to be one of your day trading staples.



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CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74-89% of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

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