How to Use Stochastics in Forex Trading

Stochastics

Stochastics Is an Oscillator

I will introduce you to another category of indicators known as oscillators. Oscillators help identify turning points, and are leading indicators, which means that they often turn ahead of currency prices. Stochastics is a popular example of an oscillator. It is not useful in choppy or trending markets; they work better in trading ranges.

The Gist of Stochastics

Stochastic studies are based on the assumption that during an uptrend, the closing price tends to be near the top. Conversely, during a downtrend, the closing price tends to be near the low for the period. Stochastic studies are made of two lines, %D and %K. The Slow Stochastics is a smoothed variation of the regular faster series and is a more preferred method because it is less subjected to whipsaws.

Stochastic is plotted on a scale ranging from 0 to 100. A reading near or above 80 is generally regarded as overbought and represents strong upward movement. A reading near or below 20 is generally regarded as oversold and represents strong downward movement. The %K line is faster and more sensitive while the %D line takes more time to turn. When the %K line crosses over the %D line, it could be an indication that the market is about to reverse course.

Stochastics, like other oscillators, is not displayed on the same graph as the currency prices. Instead, it is often displayed at the bottom of that chart and shows fluctuations on the same time scale as the prices. Figure 1 below shows an hourly chart of USD/JPY, with Slow Stochastics displayed below the price chart. The orange line is the %K line, and the purple line is the %D line. You can see that the %K line reacts faster than the %D. 

Figure 1

How to Use Stochastics in Forex Trading

It is not important to know the maths behind the calculations of the Stochastics studies, but it is important to know how to interpret this oscillator.

Stochastics can be used to:

·       Spot divergences which could indicate trend reversal of the currency pair

·       Determine overbought and oversold levels

Divergences

The strongest most reliable trading signal is the divergence between the indicator and the currency prices, which signals that a trend reversal may be looming.

Bullish divergence 

When the price falls to a new low, but Stochastics turns a higher bottom than during the previous low. It shows that the bears are getting weaker.

Trading signal

A strong buy signal as soon as Stochastics turns up from its divergent bottom.

Bearish divergence

When the price rallies to a new high, Stochastics turns a lower top than during its previous rally. It shows that the bulls are getting weaker.

Trading signal 

A strong sell signal as soon as Stochastics turns down from its divergent top.  

Figure 2

Figure 2 shows an hourly USD/JPY chart at the top and the Slow Stochastics at the bottom of the chart. When the currency price made a new low, it was not followed by a new low in the Stochastics, but instead, the Stochastics turned up higher, as indicated by the rising line. This bullish divergence signalled that the trend was about to reverse, and it would be wise to close out your shorts if you were already in the market and to be poised for an uptrend if market sentiment agreed.

Overbought/Oversold Levels

As mentioned earlier, when Stochastics rises above 80, it signals that the currency pair is overbought, and is ready to turn downward. When Stochastics declines below 20, it signals that the currency pair is oversold, and is ready to turn upward. Stochastics doesn't work well in trending markets because, during uptrends, Stochastics quickly becomes overbought and keeps giving sell signals while the currency pair rallies, and during downtrends, it quickly becomes oversold and keeps giving premature buy signals.

When %K and %D lines cross over at or below 20 and turn upward, many traders interpret that as a buy signal. A sell signal is when %K and %D lines cross over and turn downward at or above 80. Many mechanical trading software generates these as trading signals.

Figure 3

Trading Tips for Stochastics

·       Divergence is the most powerful way of interpreting Stochastics, and it gives the best buy and sell signals in the Forex market. It is more significant in a daily or hourly chart than a 5-min chart although it appears maybe only a few times a year.

·       Combine Slow Stochastics with a trend-following indicator so that you can have a better representation of the various market conditions.

It is not profitable to trade crossovers of Stochastics lines because Stochastics works differently in a trending market and in a trading range.