What is a Stochastic Oscillator?
A stochastic oscillator is a momentum indicator used to predict trend durations and potential areas of trend reversals. As you might guess, these two points define the core of the Forex market and accurately predicting them would be considered the holy grail of currency trading.
The stochastic oscillator is theoretically based on the fact that a market tends to follow a trend. A market having upward tendencies would tend to close near its high price over a given period while a market having a downward momentum would tend to finish at a price that is close to its low over a given period.
The heart of a stochastic oscillator are two values %K and %D. They can be represented as follows:
As can be deduced, the stochastic oscillator bases its functions on a 14-day period. L14 indicates the lowest low of the price during this period while the H14 represents the highest high of the currency during the same time frame. The C is basically the most recent closing price of the currency.
%D on the other hand is the 3-day moving average of the values of %K. Its function is to reduce the jagged nature of the %K values and give a more smooth and refined picture of the trend.
There are three basic variants of the stochastic oscillator; fast, slow and full. The fast one is the same as the one stated above and is characterized by jagged %K lines. The slow version essentially smooths out the choppiness in the %K values of the previous type by representing %K as a 3-day moving average (what %D did before) while the %D gives a moving average of n time periods. While the full variant is the customized version of the stochastic oscillator and thus allows you to make both %K and %D values to be moving averages of different time periods of taste-dependent lengths.
Overbought Signal
The main use of the stochastic oscillator, as stated before, is to predict the trends. To attain this the values of %K and %D are plotted on a graph having a vertical range from 0 to 100. Generally it is taken that when the value of 80 is breached, the currency is defined as overbought. This is an optimal time to sell as after this the market will have the tendency to fall.
Oversold Signal
Similar to the above scenario, when the concerned graphs go below the value of 20, the currency is deemed as being oversold. This is a great time to buy some of the currency as the market will tend to go upwards from here.
An important point regarding these two signals is that there is no hard and fast rule as to when the currency will rebound from the oversold and overbought areas. It may stay there for months or dissipate in days. Therefore it is important to gauge the bullish and bearish tendencies before committing to a move.
Why use the stochastic oscillator?
Many new traders are bogged down by the complexity of this important tool. However, after the initial learning curve you stand to gain a lot from employing the stochastic oscillator. There are two important ways in which the oscillator tends to help traders:
A stochastic oscillator compares values with the highs and lows it has on record for the last 14-day period. In a strong upward or downward trend it simply relays the values to the trader about what they are seeing on the Forex chart. However, when a divergence occurs things are different.
A divergence takes place when, for example, the highest high reached in a bullish trend is greater than the highest high generated by the oscillator. This would signal a weakening trend and seasoned traders capitalize on it despite the fact that the trend would continue upwards for a few more sessions.
Additionally, crossovers between the %D and %K graphs are indicative of trend reversals. This is so because the oscillator is signifying a performance that is a diversion from the trends obtained in the recent past.
Therefore, the stochastic oscillator is an invaluable metric in a trader’s arsenal. Every budding Forex trader should understand it and employ it in their marketing forays for optimal results.
How to use the stochastic oscillator to trade?
As mentioned in the previous section, the stochastic oscillator is a vital tool for predicting market trends. It gives a trader overbought and oversold signals, as stated before. Other critical signals, it exudes are those of prospective trends.
If the %K line falls through the %D line and goes downwards then it signifies the beginning of a bearish trend.
On the other hand, if the %K line crosses above the %D line then a bullish trend is imminent.
We have discussed divergence before but there is also another signal to it that we haven’t considered yet. Basically, %D line is used in this case as it is inherently smoother than the %K one. So, when the %D is moving in the direction opposite to the Forex graph, it signifies a divergence.
A bearish signal occurs when the Forex graph is moving upwards while the %D line is going downwards. Conversely, a bullish signal happens when the Forex graph is showing a downward trend while the %D line is showing an upward motion. However, the signal is only completed when the %K line cuts across the %D graph in a direction opposite to the price movement.
Finally, it is pertinent to mention that any budding Forex trader should invest time and energy in mastering this essential analysis technique. It will help you when you least expect it to and thus keep you in the game on the floors of the scintillating Forex market.