Another popular indicator that forex traders use, along with RSI and Parabolic SAR, is the Stochastic Indicator.
The Stochastic was developed by a guy called George Lane, who was interested in trying to create an indicator that warned you when a price was reaching a point near its previous highs when going up, and near its previous lows when going down. We all know that lines of support and resistance tend to form in markets. The stochastic tries to map that in a simple graph.
The Stochastic is all about momentum: it has 2 lines: a fast one : %K, and a slow one: %D. The lines oscillate between 0 and 100.s
And much like the RSI indicator, there are trigger lines on a Stochastic chart. Think 80/20 rule here- the lines are drawn in at the 80 and 20 levels (the Stochastic is normally a red flag on 70/30). If the chart crosses over these lines, it indicates that you are in “overbought” or “oversold” territory. Of course, this is just an “indicator”, not a gauge that is correct 100% of the time. Use it as a guide, not as a given and make sure you look at other factors and other forex indicators to give you a broader view.
There are various methods of using the Stochastic Chart as follows:
- Stochastic lines intersecting — suggests a change in trend.
- 80+ levels: high zone. Suggests pair is overbought,
- Permanently in the +80 high zone- strong bullish trend.
- Stochastic heading below 80 level on a downward path — trend reversal possibility to a down trend.
- 20- levels: low zone zone. Suggests pair is oversold,
- Permanently in the -20 low zone- strong bearish trend.
- Stochastic heading above 20 level on a upward path — trend reversal possibility to a uptrend.
Let’s look at these more closely:
1. Intersecting Stochies
Stochastic %K (fast) and %D (fast) will often cross over, a bit like moving averages at different periods.
- %K line intersects %D line from top to bottom, this is a Sell Signal.
- %K line fintersects %D line going up, this is a Buy Signal.
If you happen to see an intersection of the Stochastics in the High or Low Zone (>80 or <20), this is considered to be an even stronger signal.
As with all indicators, you can adjust the sensitivity of the %K and %D lines. We’d recommend just sticking with the default to begin with, but basically you reduce the Stochastic parameters to make it more sensitive. You’ll see more crossovers, but be careful- they’ll be more noise in their and more chance of a false signal. If the markets are moving fast, you can get away with a more sensitive set up. But it can be jittery.
2. The Stochie High/Low Zones- indentifying oversold/overbought pairs.
Just to recap, anything over 80% is considered overbought, and anything under 20% is considered oversold. But, be careful. If the trend is strong, you might see the lines camped up in these areas for long periods. As with all indicators, don’t use the Stochastic in isolation. Look at the Bollinger Bands, figure out the strength of the trade and perhaps more importantly, make sure you are away of the underlying market fundamentals and of any big news items coming up. this should just be one more tool in your box.
If your Stochastic line is in the High Zone (80+) for some time, and then drops out of it, then you might think of going short. Or, if you are a waiting bull, you’ll we watching the Stochastic lines and waiting for them to pop up out of the Low Zone (<20) .
3. Stochastic divergence
Another concept to look out for is Stochastic Divergence. In this scenario, you are looking out for subtle difference between the actual price of the currency pair and the Stochastic
Say, for example, that EURUSD is posting new lows, and the Stochastic is marking higher lows- you have a mismatch or divergence. This points to a possible reversal, and the price may flip back to the upside.
Full versus Fast versus Slow stochastic
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