What is a Stochastic Indicator and How Can I Use it?
A Stochastic Indicator is a measure of price momentum. Otherwise known as Stochastic Oscillator, it was developed by George C Lane in the late 1950's. Based upon a predetermined high and low range, it will indicate a closing price after a consistent level of either high or low closing prices measured over a set number of periods. A consistent high level near the top of the range creates an accumulation or momentum known as 'buying pressure' and a consistently low level near the bottom of the range creates a distribution or momentum known as 'selling pressure' The Stochastic Oscillator will indicate when a trend is about to turn and flags up a buy or sell signal to the trader.
This article tells you how a Stochastic Indicator is calculated and how it is used to help make successful trades.
The calculation is as follows:
100 X ratio (recent close - lowest low)/(highest high - lowest low) = %K, where the lowest low and highest high is taken over a specified period. The most common period is 14days with the highs and lows recorded for each of the 14 days and the recent close is the closing price on the 14th day. This in effect mathematically compares the latest closing price to previous prices over the number of periods being considered. Clearly, since this ration is a percentage figure, it will vary or 'oscillate' between 0 and 100 over a period of time and is represented by a %K line on your chart.
The signal line or %D line is simultaneously plotted alongside the %K line and is normally a 3 period moving average. It effectively smoothes out the oscillations making it easier to spot the turn in trend which is why it is called the signal line.
What I have just described above is in fact known more specifically as a Fast Stochastic Indicator. There is also a Slow Stochastic Indicator and a Full Stochastic Indicator which are similar but more advanced and beyond the scope of this particular article. If you follow my articles on my by blog at http://forexinvestmentmarket.blogspot.com/ I will be posting more on this subject in due course.
There is no need for you understand the mathematics here or to even make this calculation yourself because most trading software will do this for you and will be shown plotted on a chart provided by your system supplier or forex broker account.
However, unless you are using a robot to trade for you, it is necessary for you to know how to use the Stochastic Indicator to help with your forex trading decisions.
In very simple terms, if both the %K and %D lines are high relative to your horizontal 'sell' trigger line then it is a signal that the market is overbought and about to reverse. This is and indication to sell.
Conversely, if the lines are low relative to your 'buy' trigger line then it is a signal that the market is oversold and about to reverse. This is an indication to buy.
Of course the trigger lines are set to suit your own trading style, usually somewhere between 70 and 80 for the high and between 20 and 30 for the low.
Different traders interpret the Stochastic Indicator lines in different ways. For example when they intersect going up or coming down is often used as a trigger to buy or sell. Before making any real trading decisions based on Stochastic Indicators, as always you should paper trade to become familiar with then and the positioning of your horizontal trigger lines. In other words develop your own system.
Never ever use the Stochastic Indicator as your only guide to trading. You should always use a combination of indicators which all point in the same direction before you make a decision.
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