The “Stochastics” indicator is a popular member of the “Oscillator” family of technical indicators. George Lane created the Stochastics oscillator when he observed that, as markets reach a peak, the closing prices tend to approach the daily highs, and vice-versa. The Stochastics indicator is said to be “leading” since it generates signals before they appear in pricing behavior. Traders use the indicator to determine overbought and oversold conditions and the beginnings and endings of cycles in the forex market.
The Stochastics indicator is classified as an “oscillator” since the values fluctuate between zero and “100”. The indicator chart typically has lines drawn at both the “20” and “80” values as warning signals. Values exceeding “80” are interpreted as a strong overbought condition, or “selling” signal, and if the curve dips below “20”, a strong oversold condition, or “buying” signal, is generated.
The Stochastics indicator is common on Metatrader4 trading software, and the calculation formula sequence involves these straightforward steps:
- Stochastics consist of two lines formed by “%K” and “%D”;
- Choose a period “N” for “%K”, “X” for %D (Standard settings = 9,3);
- %K = 100 * (CCL – LN)/(HN – LN) where CCL = Current Closing Price, LN = lowest low of past “N” periods, HN = highest high of past “N” periods;
- %D = 100 * (HX /LX) where HX = X-period sum of (CCL – LN), LX = X-period sum of (HN – LN).
Software programs perform the necessary computational work and produce a Stochastics indicator as displayed by the two lines in the bottom portion of the following chart:
The Stochastics indicator is composed of two fluctuating curves – the “Green” %K line, and the “Red” %D signal line. Forex traders prefer a slower version of this indicator because they believe the signals are more accurate. For Slow Stochastics, %K becomes the old %D line, and the new %D is derived from the new %K. The chart above is the slower version, a setting selection on the Metatrader platform. The Stochastics oscillator is viewed as a “leading” indicator, in that its signals foretell that a change in trend is imminent, especially when lines cross into extreme regions. The weakness in the indicator is that it is difficult to discern how long in advance the signal truly is.
How to Read a Stochastics Chart
The Slow Stochastics oscillator with settings of “9, 3, 3” is presented on the bottom portion of the above “15 Minute” chart for the “AUD/USD” currency pair. In the example above, the “Green” line is the Stochastics “%K” value, while the “Red” line represents the “%D” signal line that acts like a moving average. Stochastics values below 20 and over 80 are worthy of attention.
The Stochastics Rollercoaster
The key points of reference are highpoints, lowpoints, divergences, and occasionally crossovers. The slow “Stochastics Rollercoaster” tends to be more sensitive and is favored by forex traders. The Stochastics oscillator attempts to convey pricing momentum direction changes. Typical “oversold” and “overbought” conditions are noted on the chart, and line crossings confirm these trading signals. Divergences are also important as seen in the noted “overbought” condition. Prices are reaching new highs, but the Stochastics are already receding from previous highs, a sign to sell or short.
As with any technical indicator, a Stochastics chart will never be 100% correct. False signals can occur, but the positive signals are consistent enough to give a forex trader an “edge”. Skill in interpreting and understanding Stochastics signals must be developed over time, and complementing the Stochastics tool with another indicator is always recommended for further confirmation of potential trend changes.
In the next article on the Stochastics indicator, we will put all of this information together to illustrate a simple trading system using this Stochastics oscillator.
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