Another technical indicator we’re going to discuss here on ForexGator.com is the Stochastic oscillator. So far we talked about how to trade with the RSI (Relative Strength Index), RVI (Relative Vigor Index) and even the MACD (Moving Average Convergence Divergence).
All of them, Stochastics included, are oscillators and are also called momentum indicators. They rise and fall together with price; and traders are looking for differences between them and the actual price.
The idea behind trading with an oscillator is to stick with it as it considers more candles from the past to project the current value. Because of this, traders are fond of using oscillators.
However, trading is not that simple and straightforward. This is the reason why sometimes more oscillators or signals need to be combined to give the perfect entry or exit in a trade.
Ideally, one should use an oscillator in combination with a trading theory, and not with another oscillator. If two or more oscillators are used on the same chart and timeframe, it is wise to put them on the same chart.
This can be easily done by simply attaching one oscillator on a chart and then dragging the other ones. Traders are looking for crosses between these lines to spot trend reversals or continuation patterns.
How to Use Stochastics
The Stochastics oscillator has a tremendous advantage against other oscillators; it is extremely visible, as it is being formed out of two lines. From this point of view, it is resembling the RVI, as that one has a signal line as well.
Before plotting the indicator on a chart, one can choose the periods to be used. In this case, the standard values are 5,3,3 and the %K represents the signal line.
Waiting for the Signal
The signal to buy or sell happens when there is a cross between the two lines, and that cross is forming in an extreme area. The indicator travels between 0 and 100, so there are no negative values.
The examples above show short signals generated on the USDJPY hourly chart. While they seem to be quite accurate, the problem with such signals comes from the fact that there are too many.
Somehow, they need to be filtered; if you go back in time and try to do some back-testing you’ll find out that many of them are inaccurate.
Divergences with Stochastics
For this, traders are using the classical divergences between price and oscillator. These are classical divergences, and when a signal forms in an extreme area (overbought or oversold), and a divergence appears, the signal is filtered.
This way the rate of success is higher and even good risk-reward ratios can be reached. The stop loss should be at the lowest diverging point (in the case of a short signal) and take profit when the Stochastics reaches the 20 level.
The image above shows a bearish divergence and a signal appears right after. That is a good place to short the pair, targeting a move into the 20 area and a stop loss right at the lowest diverging point.
Using Stochastics as a Trend Indicator
It is not possible to use the 0 crossovers as a continuation pattern like it is in other cases presented earlier in previous articles. However, there’s a trick traders use with Stochastics.
On the example above, it may seem that the target is not that far away and there is not much of a profit that can be made with this oscillator. This cannot be further from the truth, as the reason comes from the smaller timeframe.
When used on a bigger timeframe, like the daily chart and above, the distance the oscillator travels is, of course, further. To add to a trend on larger timeframes, traders are using the signals generated on the lower timeframes to add onto the bigger ones.
Another trick is to divide the 0-100 range the indicator has in two equal parts and to add the 50 level. This is used as a continuation pattern and a place to add to the initial position.
As it can be seen above, the fifty level provides a good place to add to a position. While on this daily chart it may be difficult to add, on the hourly chart there is surely a signal to go long from lower values.
All in all, the Stochastics should be used like any other oscillator. It is not a special indicator, and not all signals work, but when filtered with something else, like a trading theory or a trend reversal or with Japanese candlestick technics, it gives amazing results.
Next article here on ForexGator.com will deal with how to use contrarian Forex trading to achieve better results. Market psychology plays a great role in the success a trader has, so understanding it properly is a must.