How to Use Stochastic Oscillators in Forex Trading

Stochastic Oscillator is one of the momentum indicators commonly utilized in the process of Forex trading; volatile conditions are often utilized by traders to identify situations when certain currencies are overbought or oversold. Created by George Lane in the 1950s, this indicator compares a currency pair’s closing price with price range over a given period of time. Generally, the Stochastic Oscillator is highly useful in trading because it offers the trader insight on when a currency pair is at a point that they can change their direction in the long and short trading periods.

The Stochastic Oscillator is typically displayed as two lines: the %K line and the %D line. The %K line depicts the relationships of the current price to the price of a specific range for a specific period, which is normally 14 periods. The %D line is the moving average of the %K line, used to confirm signals. Both these lines range from 0 to 100 and the trader waits for a specific level in order to have a buying or selling signal. The two most commonly watched levels are 20 and 80. When the value is over 80 it means that the currency pair is overbought, when the value is below 20 it means that the currency pair is oversold.

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The most traditional approach to trading using the Stochastic Oscillator in Forex is in divergence. The opposite occurs when the price of the currency pair is different from that which is indicated by the Stochastic Oscillator. For instance, when the price is producing the higher high but the indicator, for instance, the Stochastic Oscillator, makes the lower highs, there could be a sign of reversal. There are cases in short-term trading when the primary instrument’s rate increases, but its correlation with the second currency weakens, this is considered to indicate that the current trend is weakening. Holding this thought, if divergence is identified, traders can enter their trades before the actual move to the opposite direction.

The last useful strategy we should consider is using crossovers. A buy signal is given by the %K’s cross-cutting above %D for instance when both lines are preferentially below the 20 level signifying that the stock is oversold. From this it will be concluded that perhaps the currency pair is in need of a rally. On the other hand, a sell signal occurs when %K line crosses below %D line provided that both lines are located in the upper side of the 80 level which shows an overbought picture. These crossovers are mostly applied by traders for getting perfect entries and exit points in the trade.

Like other oscillators, it can be used to confirm trends as highlighted by other indicators of technical analysis. For example, most traders combine the Stochastic Oscillator with trend-following gadgets, including moving averages, to determine the strength of a trend filter. When a trend becomes apparent and the Stochastic Oscillator is showing signs of overbought or oversold, it becomes easier for a trader to determine when to get into a position or when to exit it.

The Stochastic Oscillator is, however, useful, it is not an ideal indicator when it comes to trading when used on its own. There are other features that need to be taken into account such as the current market mood, news and trends on prices among other features. In the foreign exchange market, where multiple indicators can generate accurate predictions of the market’s direction.

In summary, the Stochastic Oscillator is a versatile and useful tool in forex trading. As such, by doing overbought and oversold signals, indicators of divergences and crossovers traders will have a higher capacity to anticipate future trends in prices and reduce risk. If used in conjunction with other technical analysis tools, the Stochastic Oscillator offers the trader the much needed confidence in the volatile Forex market.