Forex Trading the Stochastic Oscillator
Developed by George C. Lane in the late 1950s, the Stochastic Oscillator is a momentum indicator that shows the location of the current close relative to the high/low range over a set number of periods.
In this lesson we will show one very accurate trading method we like to forex trade using the Stochastic Oscillator.
First Some History Lane observed that as prices increase in an up trend, closing prices tend to be closer to the upper end of bars and in a down trend closing prices tend to be nearer the lower end of bars. Lane developed stochastics to discern the relationship between the closing price and the high and low of a bar. Typically used to identify overbought and oversold conditions the indicator consists of two lines: % K and %D. |
These two lines fluctuate in a vertical range between 0 and 100. Readings above 80 are considered overbought and readings below 20 are considered oversold.
Calculation
14 is a popular number of periods for calculation:
A 14-day %K (14-period Stochastic Oscillator) would use the most recent close, the highest high over the last 14 days and the lowest low over the last 14 days. The number of periods will vary according to the sensitivity and the type of signals desired.
Slow versus Fast versus Full There are three types of Stochastic Oscillators: Fast, Slow, and Full. The Fast and Full Stochastic is discussed later. For the purposes of this forex trading method we will only be looking at the Slow Stochastic Oscillator. The driving force behind
all three Stochastic Oscillators is %K (fast), which is found using
the formula provided above. |
Below is a 1 hour forex trading chart showing the stochastic settings for this trading method:
Be sure to set your stochastic oscillator to the same parameters.
Advanced
Look for bullish divergence between price and the stochastic oscillator as shown in the image below:
A 1 hour forex trading showing divergence and the stochastic oscillator at 14:
Trading Rules (Going Long):
- Identify divergence, in the image above this is represented by the two blue lines, make sure price is on the move down and the stochastic oscillator moving up from OVERSOLD conditions.
- Draw a trendline represented above by the pink line and draw your first support line as shown at 1371.81
- Enter the market when price breaks the trendline as well as the support area at 1371.81.
- Place your stop below the lowest candle after divergence occured.
- Go for the first area of resistance as your first target shown above at 1389.66
- You could also empoy a trailing stop depending on your style of trading.
Conclusion
Readings below 20 are considered oversold and readings above 80 are considered overbought. However, a reading above 80 is not necessarily bearish or a reading below 20 bullish. A security can continue to rise after the Stochastic Oscillator has reached 80 and continue to fall after the Stochastic Oscillator has reached 20.
Some of the best signals occur when the oscillator moved from overbought territory back below 80 and from oversold territory back above 20 but as usual it is best to use the oscillator together with some other indicator as shown above to filter out whipsaws and false signals.
Thank you for joining us in this forex trading lesson.
The Daytradeology Team
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Information, charts or examples contained in this lesson are for illustration and educational purposes only. It should not be considered as advice or a recommendation to buy or sell any security or financial instrument.