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  1. Beginner
    Early Stages for Beginners
    8 Topics
  2. Forex Terminology
    11 Topics
  3. Margin & Leverage
    2 Topics
  4. Personal Psychology Questions
    2 Topics
  5. Psychology for Beginners
    7 Topics
  6. Intermediate
    Identifying Scams
    2 Topics
  7. Brokers for Beginners
    5 Topics
  8. Technical Analysis
    13 Topics
  9. Market Structure
    5 Topics
  10. Completion
    Risk Management for Beginners
    8 Topics
  11. Fundamental Analysis
    9 Topics
  12. Advanced
    Using Indicators
    6 Topics
  13. Technical Analysis (Part 2)
    8 Topics

Stochastic

Stochastic is another popular oscillator and somewhat resembles the RSI though it has two lines on its chart. This indicator reflects the latest price closes in relation to the previous range defined by the highest high and the lowest low over a given period (14 periods by default). If  price moves closer to the period’s high (in the upper portion of the range), the oscillator will increase.

Stochastic has two lines: %K and %D. The former represents the indicator itself, and %D is the signal line, which represents a 3-period moving average of the %K line itself. Like the RSI, the Stochastic line is displayed below the main chart and is moving between 0 and 100, though its oversold and overbought zones are below 20 and above 80, respectively.

However, while many Forex traders are tempted to believe that Stochastic accurately determines the overbought and oversold levels, this is not true. The indicator simply reflects the momentum of a price, although it’s fair to say that it may indirectly point out the overbought and oversold conditions.

You will often hear that if the %K line breaks above 80, then you should go short or close long positions. Yet when the Stochastic is moving above 80, it actually suggests that the bullish trend is still strong, as price closes continue to show up in the upper portion of the range. Thus, the indicator may keep above 80 for a long time, which contradicts the recommendation that you should anticipate a bearish market right after the %K line crosses the 80 line.

How to Use Stochastic?

Here are the main types of signals provided by Stochastic:

  • Trend following – if the %K line is moving upwards or downwards maintaining the same angle and pace, it tells you that the uptrend or downtrend is still ongoing, and you can launch your trend-following strategy and go long or short depending on the existing trend. When Stochastic reaches the overbought/oversold area, don’t exit positions right away but hold on to your trades until the %K line doesn’t leave that zone.
  • Trend reversal – when the %K leaves the overbought/oversold zone shortly after entering, it may point to a trend reversal. If the indicator changes direction and breaks below the 80 level, you may open a short position and vice versa.
    For a more relevant signal, you can open your position after the intersection of the two lines. Thus, when the %K line breaks below the 80 level and crosses below the %D line, this is a more accurate bearish signal.

  • Divergences – like the RSI and other momentum indicators, Stochastic can be used to identify relevant divergences, which usually anticipate trend reversals or at least the weakening of the existing trend.

Breakout trading – sometimes the Stochastic indicator may be applied for breakout strategies. When you see that the %K line suddenly accelerates in one particular direction while the two lines are widening, then it marks the start of a new trend. If this happens when the price is breaking below a solid support or above a resistance level, then the signal is even more relevant, and traders open positions in the direction of the forming trend.