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Risk Warning: Your capital is at risk. Statistically, only 11-25% of traders gain profit when trading Forex and CFDs. The remaining 74-89% of customers lose their investment. Invest in capital that is willing to expose such risks.

How to Use the Stochastic Oscillator to Make Profitable Trades

Author: Christophe Williams
Christophe Williams
All publications of the author

Forex trading often seems complicated to the untrained mind. It is likely that you have met professional traders using technical indicators, looking at charts without knowing what they were doing. The good thing is that there are a number of ways that you can use to predict the direction of the market.

Of course, there is no one size-fits-all indicator so you may have to rely on a number of technical indicators. One of the most popular chart indicators that traders rely on is the stochastic oscillator. Luckily, you can easily understand this strategy despite the difficult name that it has.

The Stochastic Oscillator is a tool that can be used to help you identify possible reversal areas by comparing support/resistance and price levels. It is a simple indicator that helps traders identify overbought and oversold conditions, which can give them an edge when trading with the trend. In this article we will go through what the Stochastic Oscillator is, how you can use it in Forex trading and some examples of how your trading may look with this tool applied to it.

 

Understanding the stochastic oscillator


The Stochastic Oscillator is a momentum indicator that compares a security's closing price to its price range over a set number of periods. It was developed by George Lane in the late 1950s. Lane was a technical analyst and trader, who believed that the market action tends to repeat itself in similar patterns, and that by studying these patterns, one could make more informed trading decisions.

This indicator that measures the speed and direction of price movements. It can be used to predict future price movements, confirm trends, identify overbought and oversold conditions, and even find opportunities for short sellers.

Identifying reversal areas

The stochastic oscillator is a very popular technical indicator that has been around for a long time. Fortunately, you can use this tool to identify possible reversal areas by comparing support/resistance and price levels.

As mentioned earlier, the stochastic oscillator measures the speed and change in price movement. It does this by taking into consideration how many times a certain price level occurs over a certain period of time. 

For example, if your stock goes above $100 for three days in a row, you would see this as an indication that it’s overbought. This is because there have been only three instances where the stock touched this level before moving higher again (i.e., support). 

 

Comparing the price of an asset class

 

With this momentum indicator, you can compare the closing price of a security to its price range over a certain period of time. It works by calculating two values:

 The 20-day Moving Average

The 20-day moving average (MA) smoothed line, which indicates whether prices are trending up or down over time. When prices are rising, this line will be above 0, and when they're falling this line will be below 0.

 A fast sell signal occurs when an asset has crossed below its 20-day MA after having traded within that range for at least 10 days in a row. The lower your MA falls below zero during this period, the closer you get to being out of favor among investors who use them as indicators for picking stocks worth buying into at current prices.

 A slow sell signal occurs when an asset breaks below its 20-day MA and then trades back above it within the next 10 days—the longer this takes, the higher your MA rises above 0 during this period, the closer you get to being out of favor among investors who use them as indicators for picking stocks worth buying into at current prices.

 

The 200-day Moving Average

On the other hand if your stock breaks below its 200-day moving average after reaching its 200-day moving average twice within one week. You would see this as an indication that it may be entering into bearish territory where prices will likely drop further before reversing back up again towards previous support levels such as old highs.

 

Reasons Why You Should Use the Stochastic Oscillator

 

While there are a lot of indicators that you can rely on out there, there is a reason why the stochastic oscillator is a preferred indicator. Here are some of the common reasons why traders use this momentum indicator.

 

  • The stochastic oscillator can help identify potential overbought or oversold conditions in the market. An overbought condition occurs when the market has been trending upward for a prolonged period and is considered to be "overbought," meaning that it may be due for a correction or reversal. An oversold condition is the opposite, where the market has been trending downward for a prolonged period and is considered to be "oversold," meaning that it may be due for a rebound or reversal.
  • The stochastic oscillator can be used to generate buy or sell signals. When the indicator moves above a certain level, such as 80, it can be considered a buy signal, while when it moves below a certain level, such as 20, it can be considered a sell signal. This is because when the market is overbought, it is considered a sell signal and when it is oversold, it is considered a buy signal.
  • It can be used to confirm other technical indicators or chart patterns. For example, if a trader is looking at a chart and sees a head and shoulders pattern forming, they can use the stochastic oscillator to confirm the pattern by looking for overbought or oversold conditions.
  • It is a momentum indicator, which means it can help identify the strength of the current market trend. When the stochastic oscillator is in overbought or oversold territory, it can indicate a potential reversal, but if it is in between those levels, it can indicate that the current trend is likely to continue.
  • It is a relatively simple indicator to interpret, making it accessible to traders of all experience levels. The stochastic oscillator is easy to understand, which is why it is a commonly used indicator among traders. Its simplicity allows new traders to start using it right away and experienced traders to quickly identify key levels.

 

 

How to Read the Stochastic Oscillator in Forex

The stochastic oscillator is typically displayed on a scale of 0 to 100, with a reading above 80 indicating an overbought market and a reading below 20 indicating an oversold market. To read the stochastic oscillator, traders typically look for the following:

 

  1. Overbought or oversold conditions: If the stochastic oscillator is above 80, it is considered overbought, and if it is below 20, it is considered oversold. These conditions can indicate potential market reversals.
  2. Buy or sell signals: When the stochastic oscillator moves above 80, it can be considered a sell signal, while when it moves below 20, it can be considered a buy signal.
  3. Divergence: When the stochastic oscillator is diverging from the price action, it can be an indication of a potential reversal. For example, if the price is making new highs but the stochastic oscillator is not, it can indicate a potential bearish reversal. 
  4. Crossover: Traders also watch for when the %K line crosses above or below the %D line which can indicate a potential buy or sell signal.

It's important to note that the Stochastic Oscillator should not be used in isolation. Traders should use it in combination with other indicators and analysis techniques for a more accurate understanding of the market.

Overbought and Oversold Conditions 

An overbought condition occurs when the market has been trending upward for a prolonged period and is considered to be "overbought," meaning that it may be due for a correction or reversal. This is indicated by the Stochastic Oscillator reading above 80. When the market is overbought, the price has risen too quickly and the assets price may be overvalued, this may be a sign that the market is ready for a pullback, or a bearish reversal.

 An oversold condition is the opposite. It occurs when the market has been trending downward for a prolonged period and is considered to be "oversold," meaning that it may be due for a rebound or reversal. This is indicated by the Stochastic Oscillator reading below 20. When the market is oversold, the price has fallen too quickly and the assets price may be undervalued, this may be a sign that the market is ready for a rebound or a bullish reversal.

It's worth noting that these levels are not hard rules, and that the market can remain overbought or oversold for extended periods of time. Traders should use the Stochastic Oscillator in combination with other indicators and analysis techniques to confirm overbought and oversold conditions and to find the best entry and exit points in the market.

Stochastic Divergence Strategy

The stochastic divergence strategy is a technical analysis technique that uses the stochastic oscillator to identify potential market reversals. It is based on the idea that when the stochastic oscillator is diverging from the price action, it can be an indication of a potential reversal.

The basic concept of the strategy is to look for instances where the price is making new highs or lows, but the stochastic oscillator is not. When this happens, it can indicate that the market is losing momentum and a potential reversal may be imminent.

 To implement the stochastic divergence strategy, traders typically look for the following:

  • Bullish Divergence: This occurs when the price is making new lows, but the stochastic oscillator is not, indicating that the market may be due for a bullish reversal. 
  • Bearish Divergence: This occurs when the price is making new highs, but the stochastic oscillator is not, indicating that the market may be due for a bearish reversal. 
  • Entry and exit points: Once a divergence has been identified, traders can use it to enter or exit a trade. For example, if a bullish divergence has been identified, a trader may enter a long position. Conversely, if a bearish divergence has been identified, a trader may exit a long position or enter a short position.

 

It's worth noting that divergence is not always a clear signal and traders should use it in combination with other indicators and analysis techniques for a more accurate understanding of the market. Also, Divergence can also be a signal that the trend is losing momentum and not necessarily a signal of a reversal. You should also practice proper risk management and use stop-loss orders to minimize any potential losses.

 

Stochastic Crossover Strategy

The stochastic crossover strategy is a technical analysis technique that uses the stochastic oscillator to generate buy or sell signals. The strategy is based on the idea that when the %K line crosses above or below the %D line, it can indicate a potential change in market direction.

To implement the stochastic crossover strategy, traders typically look for the following:

  • Buy signal: This occurs when the %K line crosses above the %D line. This can indicate that the market is becoming oversold and that a bullish reversal may be imminent.
  • Sell signal: This occurs when the %K line crosses below the %D line. This can indicate that the market is becoming overbought and that a bearish reversal may be imminent.
  • Entry and exit points: Once a crossover has been identified, traders can use it to enter or exit a trade. For example, if a buy signal has been identified, a trader may enter a long position. Conversely, if a sell signal has been identified, a trader may exit a long position or enter a short position.

Note that different traders may use different levels of overbought or oversold, or different parameters for the %K and %D lines. It's thus important to test and fine-tune these parameters to fit the specific market conditions and the trader's personal strategy.

 

Other Indicators That You Can Use With the Stochastic Oscillator


The stochastic oscillator is often used in conjunction with other technical indicators to provide a more complete picture of the market. Some common indicators that traders use in combination with the stochastic oscillator include:

  1. Moving averages: Moving averages are a widely used trend-following indicator that can help confirm the direction of the current trend. When the price is above the moving average, it can indicate an uptrend, while when the price is below the moving average, it can indicate a downtrend. 
  2. Relative Strength Index (RSI): The RSI is a momentum indicator that can help identify overbought and oversold conditions in the market. It is similar to the stochastic oscillator in that it oscillates between 0 and 100, with readings above 70 indicating overbought conditions and readings below 30 indicating oversold conditions. 
  3. Bollinger Bands: Bollinger Bands are a volatility indicator that can help identify potential price breakouts. They consist of a moving average and two standard deviation lines that are plotted above and below the moving average. When the price breaks above or below the Bollinger Bands, it can indicate a potential price breakout. 
  4. Fibonacci Retracements: Fibonacci retracements are a technical analysis tool that can help identify potential levels of support and resistance. They are based on the idea that prices will often retrace a predictable portion of a move, after which they will continue to move in the original direction. 
  5. Candlestick patterns: Candlestick patterns are a way to visualize price action and can be used to identify potential market reversals. Candlestick patterns like the hammer, the morning star, and the evening star can be used to identify potential reversal patterns.

 

Just remember that each indicator has its own strengths and weaknesses, and it's important to use them in combination with other indicators and analysis techniques for a more accurate understanding of the market. Also, it's important to test and fine-tune the parameters of each indicator to fit the specific market conditions and the trader's personal strategy.

 

Wrapping it Up!

The Stochastic Oscillator is a technical indicator that is used in forex trading to identify potential overbought and oversold conditions. This momentum indicator also helps generate buy and sell signals, confirm other technical indicators or chart patterns, identify the strength of the current market trend, and is relatively simple to interpret. It is a popular choice among traders because it can help traders identify key levels and potential market reversals. Moreover, it can also be used in combination with other indicators and analysis techniques to provide a more accurate understanding of the market. Traders should use it with proper risk management and stop-loss orders to minimize potential losses. Proper reading and interpretation of this oscillator can help you make profitable trades when trading currency pairs on the Forex market.

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Risk Warning: Your capital is at risk. Statistically, only 11-25% of traders gain profit when trading Forex and CFDs. The remaining 74-89% of customers lose their investment. Invest in capital that is willing to expose such risks.