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The Use of Stochastic Oscillator in Forex Trading

Technical momentum indicator used to predict price turning points

The stochastic oscillator, often commonly referred to as the "stochastics" by Forex traders, is one of the most popular trading indicators, favored by Forex retail traders of varying experience.

A stochastic oscillator is a technical momentum indicator that compares a security's closing price to its price range over a given time period. Developed by George C. Lane in the late 1950s, the stochastic oscillator is a momentum indicator that reveals the location of the close, relative to the high-low range, measured over a set number, or period.

The accepted notion is that all technical indicators lag, they never lead, however, the creator of the indicator, George C. Lane, was adamant that the indicator didn't follow price, therefore an argument could be put forward that the indicator does 'lead'. According to an interview with Lane, the Stochastic Oscillator;

“Doesn’t follow price, it doesn't follow volume or anything like that. It follows the speed, or the momentum of price. As a rule, the momentum changes direction before price.”

Stochastic oscillator chart  

The Stochastic Oscillator is a popular trading indicator that helps spot the momentum changes
before price move. (Image credit: Wikimedia Commons)

The use of the stochastic oscillator

The stochastic attempts to identify bullish and bearish divergences, it can therefore (potentially) be used to foreshadow and forecast trend and (or) price reversals. This was the first, and most important, signal and potential use for the stochastic oscillator that Lane identified. The oscillator can also be used to identify bull and bear set-ups in anticipation of a future reversal. And as a consequence of the stochastic also being" range bound", it's also extremely useful for potentially identifying overbought and oversold levels.

The default setting for the oscillator is 14, the indicator measures the level of the close, relative to the high-low range over a given period of time. The basic premise of the indicator is that the divergence in the two lines offers up a signal to trade, as it’s indicating a change in sentiment.

Key levels of the indicator

Most traders will use the graphic, preset levels on the indicator (left on its standard setting), to make their trading decisions. The two key levels of 20 and 80 have become regarded as the levels at which traders are encouraged to make trading decisions. The 80 level is regarded as an overbought area, the 20 level is identified as an oversold area. Traders may close their long positions, should the indicator signal a reading above 80, and close their short positions, if a reading (level) of 20 is reached.

Many traders also monitor the 50 level and regard it as being crucial, the 50 line should be regarded as the centerline; if the oscillator crosses above the 50 line then the indications is that price is trading in the upper half of the high low range over the period represented, suggesting that moderately bullish conditions exist.

As with many of the other momentum oscillators best suited to trading ranges, the stochastic can also be used to trade with trend; when looking to identify the larger trend, the stochastic can highlight areas of pullbacks, or 'bounces'. The stochastic can also be used to trade with support and resistance. If a Forex pair or security trades near support with an oversold stochastic, then traders could look for a break above the 20 level, to signal an upturn and confirmed support test. Should the security trade near resistance with an overbought stochastic, traders would look to observe a break below 80 as a signal of a downturn and potential resistance failure.

Combining the indicator with the trading style

As with many indicators, stochastic settings depend on personal preferences, trading style and timeframe. A shorter "look-back" produces a choppy oscillator, which will 'identify' more overbought and oversold readings, whereas longer look-back periods illustrate a smoother pattern to the oscillator, delivering fewer overbought and oversold readings.

As with many other technical indicators, for its maximum potential, the stochastic should be used together with other technical analysis tools. One technical indicator with its accent on its specific qualities, cannot be relied on singularly. Perhaps by using other metrics of volume, support and resistance and by potentially identifying patterns of breakouts, we can confirm, or dismiss the signals generated by the stochastic.

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