A stochastic indicator is an excellent tool for determining oversold and overbought conditions within a particular period. Read on to understand more about this oscillator.
The stochastic oscillator comes with two lines that are:
- The indicator that is defined by %K
- A signal line that indicates the 3-day SMA (simple moving average) of %K, also referred to as %D
The intersection of these two lines predicts a trend shift. For example, what does a downward cross on a chart demonstrating a bullish trend on the signal line show? It suggests that the current closing price is similar to the minimum low of the last period than was the case in the last three sessions.
An unexpected drop on the lower part of the trading scope after a constant high price action indicated that bulls are declining. The stochastic oscillator is effective in establishing oversold or overbought conditions. It ranges between 0 and 100, with overbought conditions being above the 80 reading.
The oversold conditions read below 20. Crossovers that happen during these external ranges are said to be robust signals. Some traders overlook crossover signals that do not take place during extreme conditions.
Creating a Strategy Using the Stochastic Oscillator
When developing a stochastic oscillator-based trading strategy in forex, find a currency pair that demonstrates a lengthy and distinct bullish trend. Remember, the perfect currency pair, in this case, will have been in the overbought category for some time, with prices nearly hitting a previous resistance area.
Search for decreasing volume as an extra sign of bullish exhaustion. When the stochastic oscillator surpasses the signal line, be on the lookout for the upcoming price. While these combined signals can be a strong indication of an approaching reversal, wait for a downturn confirmation from the price. Remember, momentum oscillators often give false signals.
Stochastic Oscillator Applications
Here are the basic applications of the stochastic oscillator
Divergence happens if the security price makes a new low or high that is not indicated n the stochastic oscillator. For instance, the price assumes a new high while the oscillator fails to respond by moving to the new reading. Such action is known as a bearish divergence, and it could suggest an approaching market reversal to a downtrend from an uptrend.
When the oscillator does not register a new high, as is the case with price action, it could be an indication of a decline of an uptrend momentum. A bullish divergence takes place when market prices assume a new low that the oscillator fails to register in a new reading. Bullish divergence suggests a possible approaching upside market reversal.
It is worth mentioning that the stochastic oscillator may often generate a divergence signal before price action direction shift. For example, if the oscillator generates a bearish divergence signal, the price can continue ascending for various trading periods before dropping. As a result, experts recommend waiting for a market reversal confirmation before opening a trading position. Do not base your trades on divergence only.
· Determine Oversold and Overbought Levels
As we have seen above, an overbought level occurs when the stochastic reading surpasses 80. Oversold market conditions occur when readings drop below 20. When oscillator readings go past 80 and drop below 80, a sell signal is generated. A buy signal, on the other hand, occurs when the oscillator drops below 20 before rising above 20. Oversold and overbought levels indicate that the security price is near the bottom or top of its trading scope for a particular period.
Crossovers define the position where the intersection between the slow stochastic line (%D) and the rapid stochastic line (%K) occurs. If the %K line crisscrosses and surpasses the %D line, the scenario becomes bullish. When the %K line crosses above the %D line before crossing below it, the action suggests a bearish sell alert.
Technical Indicators that are Compatible with the Stochastic Oscillator
Momentum oscillators like the moving average convergence divergence (MACD) and the relative strength index (RSI), and moving average crossovers are ideal options that traders can leverage to share with the stochastic oscillator. Moving average crossovers can help complement the crossover trading alert generated by the stochastic oscillator.
The stochastic oscillator is a widely used technical indicator that traders can use to forecast trend reversals. Investors can also leverage this indicator to determine oversold and overbought levels in indices, shares, and currencies.