How to Apply the Stochastic Oscillator on the Forex

If you are interested in comparing the current price of a currency to that of a given time period in the past, you should apply the stochastic oscillator. Due to its usefulness it is closely watched by traders on the forex market. 

What is the Stochastic Oscillator?

The stochastic oscillator's main purpose is to measure the degree by which the currency under consideration tends to be either oversold or overbought. Thus, this indicator measures the strength of a currency.

When the value of the stochastic oscillator is calculated it is plotted on a scale from 0 to 100. If the value is more than 80, then the currency pair is being overbought. This is so since the currency is considered to be strong. On the other hand, if the value of the stochastic oscillator is less than 20, then the currency pair is being oversold. This is so since the currency pair is regarded as weak. The price is closing close to the low if the trading range.

The stochastic oscillator consists of two lines:

1. %K - defined as the fast line. In order to calculate the %K you should use the high, low and closing data.
2. %D - defined as the low line. This line represents the moving average of the fast line. This moving average of %K is calculated for a specific time period. It is classified as moving, because the most recent data is applied in the estimations, which is multiplied by the number of time periods from which the data is extracted.

Stochastic Oscillator Application on the Forex

The stochastic oscillator can be applied in order to determine when a currency pair is being oversold or overbought. If the value of the stochastic oscillator is greater than 80, then the currency pair is overbought, thus it implies selling. On the other hand, if the value of the stochastic oscillator is less than 20, then the currency pair is oversold, thus it should be purchased.

Divergence can be identified through stochastic oscillator in either of the cases:

1. Slow %K and Slow %D decline in value and an increase in the closing price is observed.
2. Slow %K and Slow %D increase in value and a decrease in the closing price is observed.

This means that divergence is identified since stochastic values and closing prices are moving in different directions. Trend reversals can be recognized by such divergences.

Another application of the stochastic oscillator concerns market timing. When the %K and %D lines cross, most market timers interpret it as the right time to either buy or sell.

If the %K and %D lines cross above 80 and the stock has reached a new high, then this is a clear indicator that the currency pair is being overbought. On the other hand, if the %K and %D cross below 20 and the stock has reached a new low, then the currency pair is oversold and the time has come when it will change its direction.

When selecting the time period that is to be applied, consideration of the trading strategy should be made. You should keep in mind that the shorter the time period is, the higher the sensitivity of the indicator to short term fluctuations. The accuracy of the provided signal will be greatly decreased.

However, a too long time period is not recommended as well. This is so, since not enough signals may be received. As a result traders may miss important information on different price movements.

The fast stochastic differs from the slow stochastic, because the first one is based on raw data. On the other hand the slow stochastic is based on the average of the fast stochastic for a particular time period. It can be concluded that a more accurate picture is get by the slow stochastic.

The calculation of the stochastic oscillator has been greatly facilitated by the introduction of various technologies. Thanks to its wide application on the forex market, you should become familiar with it and apply it whenever possible.

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