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How To Trade With Stochastics

Oct 10, 2007
Stochastics ( Slow and Fast) are amongst the most popular technical indicators used in Forex Trading. To use them correctly, we must understand their nature. In this article I will mainly discuss about this Stochastics and how to trade using them.

The stochastic oscillator is a momentum indicator to compare the closing price of a commodity to its price range over a given time span. The most important key about this indicator is the fact that the prices are likely to close near their past highs in bull markets, and near their lows in bear markets. Transaction (enter/exit) signals can be spotted when the stochastic oscillator crosses its moving average. This explains all the decisions relevant to this indicator, even when we use this indicator in combination with others. In currencies we mainly use the Stochastic Oscillator on the 15 and 60 minute charts.

Normally, traders use two stochastic oscillator indicators to assess future variations in prices.

The two Stochastics indicator 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.

Comparisons of these statistics are a good indicator of speed at which prices are changing. Ordinarily, the %K line will change direction before the %D line. However, when the %D line changes direction prior to the %K line, a slow and steady reversal is usually indicated. When both %K and %D change direction, and the faster %K line subsequently changes direction to retest a crossing of %D line, but doesn't cross it, this is a good confirmation of the stability of the prior reversal.

Currently, traders usually use the following two well known methods to make buy/sell decisions using Stochastics indicators (%K and %D):

The first method involves crossing of %K and %D signals. Analysts argue that %D can act as a trigger or signal line for %K. A buy signal can be identified when %K crosses up through %D, or a sell signal when it crosses down through %D. However, in real trading, such crossovers can occur too often. In order to avoid repeated whipsaws we can wait signal confirmation, for example, crossovers occurring together with an overbought/oversold pullback, or a peak or trough in the %D line appears. In the case that the price volatility is high, we can use simple moving average of the Stoch %D indicator to smooth out rapid fluctuations in price instead.

The second method involves basing buy and sell decisions on the assumption that %K and %D oscillate. Note that in general, %K or %D levels above 80 and below 20 can be interpreted as overbought or oversold. Therefore, for higher possibility of winning, it is recommended that buying and selling be timed to the return back from these thresholds. That means we should buy or sell after a bit of a reversal. Let phrase it in more meaningful statement: once the price exceeds one of these thresholds, we should wait for prices to return back through those thresholds to make buy/sell decisions (for example, if the oscillator were to go below 20, we should wait until it rises a little bit above 20 to start buying, if the oscillator were to go above 80, we waits until it falls below 80 to sell).

Use Stochastics in Trending market

The key is when the market is trending up, we will 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 the overbought level (above 80) and falls back below the same level.

Use Stochastic in Trend-less market

Buy when %K falls below the oversold level (below 20) and rises back above the same level.
Sell when %K rises above the overbought level (above 80) and falls back below the same level.

Remember that if we use Stochastic in combination with other signals, it would be more accurate. After having a good combination, other steps should also be taken, e.g, money management strategies, testing...before we can stick to the method.
About the Author
David Cha is a successful NY-based veteran forex trader. Now he dedicates his time to help his fellow traders to become successful in trading. Visit his website at Forex Profit Systemfor more details, for more details, free tips, resources and newsletters.
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