Using Stochastics to Trade Forex Markets
After the Relative Strength Index (RSI), the Stochastic indicator is widely used by Forex traders in order to find out top or bottoms a market may make. The indicator falls into the oscillators category and, as a consequence, it is being applied below the actual price chart.
The overall idea of trading with the Stochastic oscillator is to find out top or bottoms and these are forming mostly in overbought and oversold territories Nothing new so far when compared with other oscillators.
What makes the Stochastic oscillator a special one is the fact that it is not composed of one single line like it was the case in the DeMarker and Relative Strength Index oscillators, but of two lines. These two lines, in a way, are acting like two moving averages are acting, with one crossing below or above another by the time market is about to turn.
This is why the Stochastic oscillator is so popular: the signals generated are visible and clearly to understand and trade. There is a saying that “simple things work best” and, in this case, this is very much true.
Is this oscillator working one hundred percent of the times? The answer is no, but it is impossible missing when the market turns if using it properly.
How to Trade with Stochastic
The Stochastic is to be found on the MetaTrader 4 trading platform under the Insert tab, Indicators, Oscillators. As you can see from the list below, when it comes to all the oscillators offered with the default MetaTrader 4 settings, this one is right at the bottom of the list.
This doesn’t make it less important, though, it is just the way the oscillators are being arranged. Nevertheless, if that list is telling us something about the importance of the indicators in this category, then the RSI is topping it and this tells much about its popularity.
Coming back to the Stochastic oscillator, if selected from the above-mentioned list, a new pop-up window will appear and we can choose the parameters we want to edit (if any) or change the values that define the oscillator. The most important values out of the three ones seen below are the %K and %D ones.
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Under the default settings, they are coming with the 5 and 3 value, and it is being said that the %D is the “fast Stochastic”, while the %K is the “slow Stochastic”. This is what gives the two lines of the oscillator and when the fast Stochastic crosses below the slow one, the market is turning bearish, while a bullish cross is forming when the fast Stochastic is moving above the slow one.
If you click the OK button on the chart above, the oscillator is being plotted on the screen. The two “lines” are being represented in different colors, in order to make the difference between the slow and fast Stochastic and to quickly see the crossing between the two lines.
Stochastic travels between 0 and 100 and any value below 20 is considered to be oversold, while any value above 80 is considered to be overbought. One thing that should be taken into account here is that this oscillator is travelling when the market is in a consolidation as well. For example, in Asian sessions, when the market is mostly consolidating, the Stochastic will still travel between overbought and oversold levels, or the other way around.
Trade Crosses Above 80 and Below 20
It goes without saying that the standard interpretation is to look for the fast Stochastic line to cross below the slow one in an overbought or oversold level. That is, look for the cross to form above 80 or below 20 before actually entering the market.
A classical entry would look like the ones above, with the crosses happening above the 80 and below the 20 levels. The other crosses should be ignored. As you can see above, there are some other crosses that happen in between those levels and even beyond them, without a market to turn, though. How to make sure we’re not caught in a wrong trade due to a fake signal?
Trade Divergences Between Price and Stochastic
In order to avoid a fake signal, divergences can be used. These divergences are acting in the same way like we mentioned here on our Forex Trading Academy by the time we discussed the Relative Strength Index (RSI) and the DeMarker oscillators.
The example below shows a bullish divergence that happens when the oscillator is not confirming the way the price is moving and traders are going long by the time the second bullish cross in the Stochastic is forming. As a take profit, this can vary based on the strategy used and one of the most popular practices is to trail the stop on any good entry.
Use Stochastic as a Continuation Pattern
This oscillator can be used as a continuation pattern as well and in order to do that we should simply add a new level. Because the 80 and 20 are already overbought and oversold levels, the 50 level comes in handy as it is right in the middle of the range.
Adding the 50 level, or any other level, as a matter of fact, is quite a simple thing to do in the sense that one should simply right-click anywhere on the chart, and under the Indicators List, the Stochastic can be edited.
The pop-up window allows under the Levels tab to add any level you want, to change its structure, color, visibility, etc., in such a way that it is showing what it is intended to show. The Stochastic oscillator with the 50 level added should look like the chart below.
The idea is to buy a cross of the 50 level after Stochastic is turning from overbought or oversold level and to hold it until a signal in the opposite direction appears. While it is not working one hundred percent of the times, it gives a great incentive for riding a trend that otherwise might be missed.
Using the three methods described in this article will have great results if ALL the signals will be taken. This way, an account will end up being hedged at one moment of time but in time all the trades will end up being closed.
The usual caveat applies as well here, and that is that the bigger the time frame the Stochastic oscillator is applied to, the more powerful the implications are. To trade all those strategies on a bigger time frame, though, requires a bigger trading account.
Other educational materials
- How to Use Parabolic SAR to Buy Dips or Sell Spikes
- Finding Entry and Exit Levels with Momentum Oscillator
- Trade Forex with Volumes Indicator
- Bill Williams – How to Use Williams Indicators When Trading Forex
- How Do I Make a Profit from Forex Trading?
- Forex Market Terminology
Recommended further readings
- Derivatives in Financial Markets with Stochastic Volatility Jean-Pierre Fouque, George Papanicolaou, K. Ronnie Sircar, Cambridge University Press, 3.07.2000
- Notes on Stochastic Finance Nanyang Technological University