How to Trade with Stochastic Oscillator (based on dailyfx.com article)
- Slow Stochastic provides clear signals in a forex strategy
- Take only those signals from overbought or oversold levels
- Filter forex signals so you are taking only those in the direction of the trend
Stochastic is a simple momentum oscillator developed by George C. Lane
in the late 1950’s. Being a momentum oscillator, Stochastic can help
determine when a currency pair is overbought or oversold. Since the
oscillator is over 50 years old, it has stood the test of time, which is
a large reason why many traders use it to this day.
Though there are multiple variations of Stochastic, today we’ll focus solely on Slow Stochastic.
Slow stochastic is found at the bottom of your chart and is made up of
two moving averages. These moving averages are bound between 0 and 100.
The blue line is the %K line and the red line is the %D line. Since %D
is a moving average of %K, the red line will also lag or trail the blue
line.
Traders are constantly looking for ways to catch new trends that are developing. Therefore, momentum oscillators can provide clues when the market’s momentum is slowing down, which often precedes a shift in trend. As a result, a trader using stochastic can see these shifts in trend on their chart.
Momentum shifts directions when these two Stochastic lines cross.
Therefore, a trader takes a signal in the direction of the cross when
the blue line crosses the red line.
As you can see from the picture above, the short term trends were
detected by Stochastic. However, traders are always looking for ways to
improve signals so they can be strengthened. There are two ways we can
filter these trades to improve the strength of signal.
1 - Look for Crossovers at Extreme Levels
Naturally, a trader won’t want to take every signal that appears. Some signals are stronger than others. The first filter we can apply to the oscillator is taking cross overs that occur at extreme levels.
Since the oscillator is bound between 0 and 100, overbought is
considered above the 80 level. On the other hand, oversold is considered
below the 20 level. Therefore, cross downs that occur above 80 would
indicate a potential shifting trend lower from overbought levels.
Likewise, a cross up that occurs below 20 would indicate a potential shifting trend higher from oversold levels.
2 - Filter Trades on Higher Time Frame in Trend’s Direction
The second filter we can look to add is a trend filter. If we find a
very strong uptrend, the Stochastic oscillator is likely to remain in
overbought levels for an extended period of time giving many false sell
signals.
We would not want to sell a strong uptrend since more pips are available in the direction of the trend.
Therefore, if we find a strong uptrend, we need to look for a dip or
correction to time a buy entry. That means waiting for an intraday chart
to correct and show oversold readings.
At that point, if Stochastic crosses up from oversold levels, then the
selling pressure and momentum is likely alleviated. This provides us a
signal to buy which is in alignment with the larger trend.
Stochastic Oscillator Blau_TS_Stochastic:
Stochastic Oscillator is based on Stochastic Index by William Blau (see Momentum, Direction, and Divergence: Applying the Latest Momentum Indicators for Technical Analysis).
Author: Andrey N. Bolkonsky