Stochastics are amongst the most
popular technical indicators when it comes to Forex Trading. Unfortunately most
traders use them incorrectly. In this article we will review the correct way to
use this popular technical indicator.
George Lane developed this indicator
in the late 1950s. Stochastics measure the current close relative to the range
(high/low) over a set of periods.
Stochastics consist of two lines:
%K – Is the main line and is usually
displayed as a solid line
%D – Is simply a moving average of
the %K and is usually displayed as a dotted line
There are three types of Stochastics:
Full, fast and slow stochastics. Slow stochastics are simply a smother version
of the fast stochastics, and full stochastics are even a smother version of the
slow stochastics.
Interpretation:
Buy when %K falls below the oversold
level (below 20) and rises back above the same level.
Sell when %K rises above de
overbought level (above 80) and falls back below the same level.
The interpretation above is how most
traders and investors use them; however, it only works when the market is
trendless or ranging. When the market is trending, a reading above the
overbought territory isn't necessary a bearish signal, while a reading below de
oversold territory isn't necessary bullish signal.
Trending market
When the market is trending is
necessary to adapt the oscillator to the same conditions: When the market is
trending up, then the signals with the higher probability of success are those
in direction of the trend “Buy signals”, on the other hand when the market is
trending down, selling signals offer the lowest risk opportunities.
Thus when the market is trending up,
we will only look for oversold conditions (when the stochastics fall below the
oversold level [below 20] and rises back above the same level) to get ready to
trade, and in the same way, when the market is trending down we will only look
for overbought conditions (when the stochastics rise above de overbought level
[above 80] and falls back below the same level.
Taking all overbought/oversold
signals during a trending market will lead us to many whipsaws. If you are not
comfortable with the number of signals given, try expanding your trading to
other currency pairs.
Trend-less market
During a ranging market we could use
the interpretation explained above to trade off stochastics.
Divergence
Divergence trades are amongst the
most reliable trading signals in the Forex market. A divergence occurs either
when the indicator reaches new highs/lows and the market fails to do it or the
market reaches new highs/lows and the indicator fails to do it. Both conditions
mean that the market isn't as strong as it used to be giving us opportunities
to profit from the market.
Stochastics can also be used to
trade off divergences.
Price behavior
A price behavior can be incorporated
into any kind of system or Forex strategy. When using divergences or
overbought/oversold condition with a price behavior approach, the probability
of success of our signals increases enormously. Why? Because price dictates at
the end, how all indicators will behave, it also gives us a lot of information
about the probable direction it will take in the future.
