The Best Way to Use Stochastic Oscillators

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Investors have used stochastic oscillators for more than 50 years to predict market momentum and inform investment decisions. We have established the basics you need to know to start incorporating stochastic oscillators into your playbook.

Stochastic oscillators in a nutshell
In stock trading, stochastic oscillators are a momentum indicator intended to help forecast abrupt changes in price by examining the rate at which the price of a security has fluctuated over time. The tool is based on the analytical concept of support and resistance, an analysis of the stock market that posits that the price will reverse once it reaches a certain predetermined threshold. Stochastic, or randomly determined, refer to the current closing price of a security relative to its lowest and highest closing prices over a stipulated period of time.

Dr. George Lane realized that price momentum, or the rate at which a security changes in price, will reverse direction before a real price change occurs to disrupt the current trend. With this in mind, he created stochastic oscillators to measure momentum (rather than price or trade volume only) to serve as a preliminary indicator to buy or sell a security before a market reversal occurs. Today, investors also use stochastic oscillators to determine when to follow strong trends and identify divergences.

Identification of stochastic trends
On a stochastic oscillator chart, the indicator is measured on the y-axis and can range in value from 0 to 100. The x-axis of a stochastic oscillator tracks time and generally spans 14 periods. If the indicator reading is below 20 at any given time, the price momentum of that security is often interpreted as oversold. Similarly, readings at the top of the stochastic oscillator range (80+) are usually read as overbought. As a general rule of thumb, overbought security is likely to decline, while one that is oversold is likely to rise, but don’t feel too comfortable with that rule just yet.

Strong trends
Overbought and oversold readings do not always indicate that a security’s price will turn in the direction, so it is important to consider the strength of the trend in addition to the value of the stochastic oscillator. Security may remain overbought if prices continue to close at a value equal to or greater than the previous closing price or what is known as a strong uptrend. Similarly, security can remain lower during a strong downtrend, when prices consistently close at or below the existing lower range.

Before acting on the overbought or oversold readings, weigh the stochastic oscillator values ​​against the largest market trends and invest in the direction of the broader trend to take the least amount of risk. If the two lines of your stochastic oscillator remain crossed in the same direction during an uptrend or downtrend, it can also be an indication that the trend is still strong and not yet ready for a reversal.

Trend divergences and reversals
When a price reaches a new extreme (high or low) and that swing is not reflected on its stochastic chart, it is considered a divergence. For example, if the price of security closes at an all-time low, but the stochastic oscillator reflects that same price drop as a higher low than previously recorded, it may be an early indicator that the price trend will reverse. If this were true, the most lucrative investment option would be long-term. Conversely, if a price closes at a new high but its stochastic indicator forms a lower high than previously recorded, it may indicate that the trend is ready for a reversal (that is, the price will decline). In such a case, it would be advantageous to fall short.

Once you identify a divergence, keep an eye out for other early confirmation signals that may indicate a trend reversal. Stochastic oscillator signals can take the form of:

Crossing of signal lines or an indicator reading that moves outside the current overbought or oversold range (+20 or −80, respectively)
A stochastic oscillator reading that traverses the median of the chart (i.e. 50)
A fall or increase in price that corresponds to a change in trend.

Stochastic Oscillators and Forex
Forex is unique in the sense that each transaction is done in pairs. In any forex trade, an investor must buy one currency and sell another currency simultaneously. Stochastic oscillators can be used to help determine whether to buy a currency long or short for the greatest potential profit. In the same way that stochastic indicators are used to help predict trends and reversals of values ​​and values, they can be leveraged to better understand momentum and price trends for a single currency.

Conclusion
It is worth mentioning that not all early signals are accurate, and even the most advanced slow oscillator charts can produce “false signals”, cases in which a price moving in one direction suddenly pivots without warning and thus, Therefore, it produces a false signal. For the most accurate and complete information, examine stochastic oscillators in conjunction with other analytical models, such as moving averages, and compare your predictions with broader market trends.

About the author

Nafees Saifi // entrepreneur, author, trainer, and stocks and FX trader. 
Nafees Saifi is a professional FX trader from, India. Nafees has extensive experience trading commodities, bonds, and equity futures in the Asian, European, and US markets. Nafees holds a Bachelor of Finance and Economics degree and is focused heavily on Investment Finance and Quantitative Analysis.

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