Lesson 4: Stochastic Oscillator

Stochastic Lines and Forex Signals

Overview

The Stochastic Oscillator produces three types of signals:

  1. Crossovers

  2. Divergence (strength of trend)

  3. Overbought / Oversold designations

 

Crossovers

  • A crossover occurs when the %K line (the fast stochastic) intersects the %D line (the slow stochastic).
  • Because the %K line reacts more quickly to market changes, it oscillates at a faster rate then the %D line. Under certain conditions, it can catch up to, and cross over, the %D line.
  • When the %K Stochastic crosses over and moves above the %D Stochastic, the interpretation is that the market rate is gaining at a faster rate than the average represented by the %D Stochastic. This increase in price strength is considered a buy signal.
  • A sell signal is the result of the %K Stochastic crossing under the %D Stochastic. This is because the faster moving %K line is declining at a faster rate than the overall, downward trend.


%K Stochastic Crossovers
Examples of %K Stochastic Crossovers

Traders also pay close attention to the 50-level crossover which occurs when the %K Stochastic crosses the 50 line on the scale. When the %K line crosses over the 50 level, the exchange rate is seen as moving into a stronger position and is interpreted as a buy signal. When the %K line crosses under the 50 level, the exchange rate is said to be weakening and is a sign to sell the currency pair.

Divergence

  • Divergence is simply the difference – or the gap – between the %K and %D Stochastic lines.
  • Because the %K line moves faster than the %D line, the divergence (the gap) between the two stochastics increases as a trend gathers momentum. However, the lines come closer together as momentum wanes in the prelude to a rate reversal.


Stochastic Divergence
Example of Stochastic Divergence

Overbought and Oversold Designations

  • Once the %K line climbs into the 80 and above region of the Stochastic scale, analysts consider this to be an overbought condition. This could lead to a sell-off forcing the price downwards.
  • When the %K line falls below 20 on the Stochastic scale, the market may now consider the currency pair to be oversold. As a result, traders may start buying thereby lifting the price higher as the market scoops up a "bargain".


Stochastic overbought oversold conditions
Example of Overbought and Oversold conditions

When acting on any Stochastic Oscillators market signal, you should always confirm the signal with another technical indicator. The Relative Strength Indicator is an excellent option for verifying the veracity of the current trend, while Bollinger Bands provide insight into the volatility of the currency pair.

If %K Stochastic Falls Below 20 – currency pair is considered oversold – seen as a buy signal

If %K Stochastic Rises Above 80 – currency pair is considered overbought – seen as a sell signal.

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