Stochastic is an indicator created by George Lane in the late 1980’s. It indicates when an asset is overbought or oversold. It can also indicate an impending breakout or trend reversal.
There are a few variations of stochastic,but in Lane’s original version it contains two lines. The first of the lines is called %K. The second is called %D.
%K is calculated by taking the highest high and lowest low of a preceding time period and defining a range using those values. Within this range, the price is then expressed as a percentage of its distance from the bottom of the range. A %K of 50% indicates that the price is in the middle of its current range. A %K above 80% indicates that the price is near the top of its range. A %K below 20% indicates the price is near the bottom of its range.
The time-period used to define the range can be any number. In the original version, the previous 14 periods were used to define the range. Many stochastic indicators today use a 5-period range instead of a 14-period one.
%D is calculated by taking a 3-period moving average of %K. In the original version, this is a “slow” line that is smoother than %K. Crossovers between these two lines are used as buy and sell signals. Many modern versions of stochastic do not show %K at all. Instead, they show %D and a second line that is a 3-day moving average of %D. Regardless, most variations of stochastic have two lines, and crossovers of these lines are used as signals.
The chart above uses a hidden %K defined by a period of 14 days. The two lines that are shown are a “fast” sea-green line and a “slow” dotted red-line. In this chart, we can see that the stochastic for USD/CHF fell below 20% in late August, 2018. This implies there was strong downward momentum.
In late September, the fast (sea green) line crossed the slow (dotted red) line from below and both lines moved above 20%. This move was accompanied by a widening of the distance between the two lines. After this signal occurred, the price moved from 0.96596 to 1.01095, a gain of over five hundred pips.
From late September to mid-November, stochastic stayed above 80%. This indicated strong upward momentum. But in mid-November, the fast line crossed the slow line and both lines moved below 80%. In addition, the space between the lines widened. This indicates that a trend-reversal may be occurring.
How to trade using stochastic
There are strategies that traders can use to take advantage of the information provided by stochastic. Here are a few:
- When stochastic is above 80%, consider it “overbought.” Look for chances to go short.
- When stochastic is below 20%, consider it “oversold.” Look for opportunities to go long.
- When stochastic crosses over and moves out of oversold condition, buy the pair.
- When stochastic crosses over and moves out of overbought condition, sell the pair.
- When the price is going up and stochastic is going down, this is a “divergence.” Sell.
- When the price is going down and stochastic is going up, this is a “divergence.” Buy.
The stochastic indicator is a measurement of the momentum of price over a given period of time. It can be used to identify overbought and oversold conditions, catch breakouts, and find impending trend reversals. It’s an excellent tool to find profitable Forex trading opportunities.