Forex trading involves a lot of tools, in-depth analysis, and strategies. One of the most helpful tools is the stochastic oscillator. This article will discuss how the stochastic oscillator works and some strategies for it.
Understanding the Stochastic Oscillator
The stochastic oscillator is a momentum indicator used in Forex trading to foresee the likeliest trend reversals. It compares the closing price to the trading range over a period to measure momentum. When toggled, the stochastic oscillator appears as a chart with two lines (the %K and %D lines).
The %K line in the chart stands for the indicator. The %D stands for the signal line reflecting the three-day simple moving average (SMA) of %K. On occasion, %K and %D will intersect, which is what you’ll be looking at when you read the stochastic oscillator.
Notice also that the oscillator’s values are bound between 0 and 100. The graph also shows two horizontal lines running across the chart. These two horizontal lines are usually placed by default at 80 and 20. These lines indicate when the market is overbought (80) or oversold (20).
These are the essential things to learn about stochastic oscillators. Do you want a more beginner-friendly explanation of the stochastic oscillator? You can find out more about the stochastic indicator explanation.
Fast vs. Slow Stochastic
The stochastic oscillator has two stochastic types: fast and slow. The significant difference between fast and slow stochastic is the oscillator’s sensitivity to market movements. Often, this sensitivity has direct relations to the length of time.
The fast stochastic is more sensitive to a change in price. Thus, it creates more trading signals than the slow stochastic. Many people also refer to the %K line as the fast stochastic indicator.
The slow stochastic smoothens the %K line by averaging over a set period, usually over three days. Usually, you’ll see it reflected in the %D line. Thus, the %D is an average of the smoother %K.
How the Stochastic Oscillator Gets Used in Forex Trading
The stochastic oscillator is one of the many tools used by millions of Forex traders worldwide. While it has millions of users, people use it in different strategies to earn money.
There are three methods of using the stochastic oscillator. We already mentioned one of them earlier. To recall, look at the points where %K and %D cross over and use them as trading signals. For example, if %K crosses below %D, consider selling. Or, if %K crosses above %D, look at it as a buy signal.
The second method is to check it to indicate any potential reversals by looking at the overbought and oversold regions. For example, the %K goes into overbought territory. Look at this as a preliminary warning of the possible top. Then, when the line dips out of the overbought region, it can be a sell signal.
The third one is to look at the divergences between the price and the stochastic oscillator. For example, the stochastic oscillator echoes the upward movement of your stock’s price. As you follow the graph, the price continues to rise, but the graphed oscillator starts plateauing or dipping. This difference between the price and oscillator can be a signal of a potential reversal.
You can also use all three methods at the same time for a clearer signal to trade. You can even use it with other momentum indicators.
Things to Keep in Mind When Using the Stochastic Oscillator
The stochastic oscillator isn’t 100% accurate. Because it’s reacting to previous market prices and movements, it can create false signals. Thus, before you make trading choices, always be critical of the market’s movements. Don’t depend solely on these indicators.
Another thing to remember is that the stochastic oscillator settings are customizable. You can change its limits for the highest highs and lowest lows. Instead of 80, you can change the market buying limit to 75, for example. The same applies to the default limit of 20 for oversold stocks.
You can also change the timeframe for the %D line. The same goes for the number of periods that the stochastic oscillator will measure. The default setting is 14 periods, referring to days, weeks, months, or even an intraday time frame.
RSI vs. Stochastic Oscillator: Which Is Better?
The RSI or relative strength index is another momentum indicator. Unlike the stochastic oscillator, RSI measures the speed of price changes or movements. The stochastic oscillator works well when the market is trading in steady ranges.
Again, how you use the RSI and stochastic oscillator will depend on your strategies. You may prefer stochastics because they’re more useful in choppy or sideways markets. Or, you can check the slow vs. fast stochastics along with the RSI to decide how you’ll trade.
There are many reasons why the stochastic oscillator is popular among Forex traders. It’s easy to read, use, and set up. One quick look at the stochastic oscillator graph can already tell you a lot about future trends.