How To Use The Stochastic Indicator In Forex Trading

The stochastic indicator is dynamic. It indicates changes in market momentum (direction) and rate of change (velocity).

More simply put, this indicator is used to determine when a Forex trader should buy or sell. This means that by applying three key inputs for which both long-term and short-term traders can weigh their decisions. 

We can measure our current comparative position to one another. While identifying levels at which we may want to take action.

What Are The Inputs Of A Stochastic Indicator?

The inputs of the Stochastic are the current price, the previous price, and the highest high or lowest low, in a given period. This means that it is based on percentage values.

The most popular period considered by the Stochastic indicator is 14 days. The stochastic will also take the 20 days moving average of the 14 days to give a reading of overbought and oversold.

The way it works is that the price is plotted on a graph with two lines (one red and one blue). Where the line oscillates between 0 and 100. A value above 80 would show an overbought condition. While anything below 20 shows an oversold condition.

The default time frame for most traders using this indicator is 14 periods, which calculates and plots a new reading every 14 days. But you can change this period based on your trading strategy. Traders who trade longer-term strategies tend to use longer timeframes such as 50 or 200. While trend traders tend to use shorter timeframes, such as 5 or 10.

What Time Frames To Trade?

When it comes to what time frames to trade, Stochastic can be used on any time frame you want. The trick is that there are typically tighter spreads in the lower timeframes. This makes sense if you think about it.

Because more traders are trading these smaller periods. This contributes to the number of trades taking place. If the spread is tight, then you will pay less commission. This means that your profit will be smaller when trading with shorter timeframes.

You need to understand how much each pip matters in your strategy. You can make up for small spreads if you adjust other things like stop-loss size, entry points. Autopilot feature, and high demand from brokers because of the high popularity of this indicator.

What Are K And D In Stochastic?

The stochastic oscillator is a measure of how much the trend has progressed. “K” in stochastic is the “overbought line.” This means that when the price moves above this line, it means that buyers are tending to buy too many stocks.

Meanwhile, “D” in stochastic is the “undersold line,” meaning that when prices move below this. It signals a time when there are not enough buyers for stocks and sellers have too much power.

In other words, the % K is the current price as a percentage of the latest high-low range. % D is the difference between the high and low prices over a set period, for a given time frame that measures a stock’s momentum.

EMA stands for Exponential Moving Average. This particular type of moving average can be used to identify if an asset’s price stays above or below its average price.

The Indicators Explained…

This indicator is used to measure market momentum concerning itself. You need the stochastic %K, the stochastic %D, and an Exponential Moving Average of these lines on a 15-minute time frame.

The first input is the stochastic %K-line. Which takes a measure of recent price activity and compares it to previous values. This is based on how often certain events occurred over some time.

Whether they were closer together or further apart (hence why many refer to this as “overbought” and “oversold”). It sets up an oscillating range between 0% and 100%.

When the range is expanding, the market is considered more overbought or bullish. As a rule, forex traders should only buy when the %K-line falls below 20%. Meaning that momentum is slowing and may be due to fall.

The second input is the stochastic %D-line. This takes a measure of a recent price change and compares it to previous values. This measures how fast something changes over some time.

Since “change” doesn’t have a set time, it is hard to know when it will happen. Many people refer to this as “overbought” and “oversold.” It sets up an oscillating range between 0% and 100%.

When the range is expanding, the market is considered more oversold or bearish. As a rule, forex traders should only sell when the %D-line is currently above 80%, meaning that momentum is accelerating and may be due to rise.

The third input is the EMA of both these lines on a 15-minute (20-30 minute) time frame. This line could be interpreted in two ways. If you want to know when the market is doing well, then you can look for signals. If you want to be able to take advantage of when the market goes bad. Then you should take advantage of the mean reversion techniques.

Using The Lines To Enter A Trade

If you are looking for entry signals, this means that long positions can be triggered when price action approaches the %K-line from below. With stochastic oscillating between 20% and 80%.

Short positions can be triggered when price action approaches the %D-line from above. With stochastic oscillating between 80% and 20%.

Using The Lines To Exit A Trade

If you are looking for exit signals, this means that long positions can be exited if we see a bearish crossover by the %K-line crossing below %D-line. And stochastic oscillating between 0% and 100%.

Short positions can be exited if we see a bullish crossover by the %K-line crossing above the %D-line. And stochastic oscillating between 0% and 100%.

Using The EMA Of Both Lines As Mean Reversion Indicator

When using the EMA of both lines as a mean reversion indicator (which is more like a filter for this indicator). We will want to see the EMA of both lines at a “zero line” convergence.

Again, this is typically used for either, market entry or exit signals. Since it provides us with a short-term price equilibrium. In other words, when the two lines cross each other and they move in a different direction from one another. But they both start to go in the same direction as the main trend.

The stochastic oscillator moves between 0% and 100%. If our EMA of both lines are converging on a zero line (0%) while moving in different directions from one another. Then we have a potential mean reversion opportunity early within a trend. We would place entries accordingly. Depending on which way our 15-minute (20-30 minute) EMA of both lines is moving.

It is difficult to know when prices are going up or down. These indicators can help us understand the price movements. The reason we use them instead of just looking at how high or low prices are is that they can filter out false signals. And give us an early warning about when prices may be changing.

Traders might miss opportunities if they use pure price action instead of using other methods. The Stochastic oscillator might help because it filters out the noise.

So while there are pros and cons for each method, many traders prefer to use them in conjunction with each other. This article has only talked about how to read the Stochastic oscillator. Keep in mind that it takes practice and more tricks to help lessen whipsaw trades.

How Does A Stochastic Oscillator Work In Forex?

A stochastic oscillator is a non-lagging indicator that helps track the momentum of a stock. The stochastic oscillator is judged by the position of the two lines: the average and variance. These two lines are related to each other through a mathematical equation.

When one goes up, the other will go down and vice versa. The forex traders use the stochastic oscillator to help them determine when to buy and sell in forex markets.

How Do We Determine When To Buy Or Sell?

To figure out whether you should buy or sell, first, you must determine if the market is overbought or oversold. The Stochastic indicator tells us when the market is overbought or undervalued. It ranges from 0 to 100.

If a stock goes up and the stochastic goes up too, but it never reaches 80. This means that there is not much momentum for our trade and the price will drop soon.

At this point, if you were trading with a long-term strategy using a daily chart. You would want to wait for the pullback and then buy again.

If the price of our trade goes up and the stochastic goes down but never touches 20. This means that there is not much momentum for our trade. Which might mean that the price will soon go back up.

At this point, if you were trading with a long-term strategy using a daily chart, you would want to wait for the bounce and then sell again.

The best way to understand what is happening is by looking at the bigger picture on your 4-hour chart.

For example: If we have been trading in an uptrend on the daily chart. But suddenly, it starts heading south, don’t panic. If you see prices on the market go down and the stochastic indicator shows that the market is oversold. This is a good indication that it will go up soon.

This can be shown on a 4-hour chart:

At point 1 we were in an uptrend on our daily chart. The stochastic was above 20 and had just touched 70 which meant that there was a lot of momentum behind the trade.

Price action went below the 200 MA for a little while, but it did not stay there long. The stochastic never got to 20, which means the market is oversold. This means there may be some bullishness ahead as traders re-enter the trade as it goes back up.

Point 2 shows where price action went back up and touched the 200 MA.

Point 3 shows stochastic touching 20 (indicating an oversold market). Stochastic going below 80 and staying there means there is no momentum behind this trade.

Price action kept going down and got to point 4. This was a sign that we could be near a bottom because you can see those stochastic shows that the market may be oversold (touching 20).

Finally, at point 5, we see price action heading north again as stochastic turns around and begin trending upwards for an uptrend. This indicates again that the more likely scenario of the market heading up has now taken place.

This information will better help you understand how to trade the Stochastic and how it relates to your 4-Hour Chart.

You can use the Stochastic just like any other indicator. I would recommend that you use it on multiple timeframes and also with other indicators. That way, you will have a better picture of where the market is going next.

Benefits Of Using A Stochastic Indicator

This is a good trading strategy because we know what the market’s doing and we make the necessary adjustments.

For example, if we see that the Stochastic lines are below 20 (blue line), then we should sell our stocks to make money.

If we see that the Stochastic lines are above 80 (red line), then we should buy stocks to make money. It’s always good to be aware of what’s going on in the market and this indicator helps us do that.

FAQ

Is RSI Or Stochastic Better In Forex?

Stochastic is better for markets because the indicator fluctuates. While the stochastic fluctuates, it is less reliable because it only tells you whether the market is overbought or oversold. It doesn’t give specific price levels.

RSI gives more precise levels but doesn’t fluctuate as much as stochastic does. Stochastic is a good indicator for day-trading. It can be used with other indicators to get an idea of what might happen in the market. For swing trading, RSI would be better for entry and exit points.

What’s The Difference? RSI is different than stochastic. RSI gives more points to go in and out of the market. But stochastic gives more accuracy when you enter and exit markets at certain levels. Stochastic gives false signals when currencies are flatlining, whereas RSI doesn’t.

Because RSI moves up/down in smooth motions, giving accurate oversold readings during sideways markets. However, both indicators can become unreliable in high volatility markets. Where sudden fluctuations can happen quickly.

What Is The Best Setting For Stochastic In Forex?

The best setting for stochastic in forex is 14. Because you want to make sure you get a clean crossover. And the best time frame for stochastic in forex is 1 hour. Because it’s a short-term indicator and not a long-term indicator.

When Not To Use The Stochastic Indicator In Forex Trading?

Stochastic is only predictive of short-term trends. It can be used as a leading indicator for the ending of trends and sideways markets. But not when you’re trading for an extended amount of time.

So to use the stochastic correctly, make sure your timeframe is 1 hour or less. Or you want to day-trade. And set it at 14 periods with a slow %K line and fast %D line.

Which Forex Indicator Is Better For Day-Trading?

Stochastic is better for day trading because it gives more precise entry points for buying dips and selling peaks.

Whereas RSI doesn’t give as much precision when small fluctuations happen frequently in a short period. To buy the dip, you need a stochastic with rapidly changing numbers that pass through 80 and 20 (overbought and oversold).

When this happens, prices will eventually move back down and allow us to profit from our trades. As we know, markets love to retrace before continuing onwards in large movements. This way we can buy low and sell high without getting stopped out too early.

What Is The Mathematical Formula Of The Stochastic Oscillator?

The Stochastic Oscillator is calculated by taking the difference of the closing price (CP). And the simple moving average (MA). Then multiplied by 100: STOCHASTIC FORMULA = 100(1/4period SMA – Close)/(3period SMA – Close).

If both lines are above 80, it’s considered overbought. And if both lines are below 20, it’s considered oversold. When the fast line crosses above or below the slow line, this gives us a buy or sell signal.

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