The stochastic oscillator is a momentum indicator used in forex trading for detecting probable trend reversals. This momentum indicator compares the closing price to the trading range over a particular time.
The displayed stochastic oscillator actually consists of two lines: the indicator itself, denoted by%K, and a signal line denoted by%D, which represents the three-day simple moving average (SMA) of%K. When these two lines connect, it indicates the possibility of a trend change.
A downward cross of the signal line on a chart with a clear bullish trend, for example, shows that the most recent closing price is closer to the lowest low of the look-back period than it has been in the preceding three sessions. A quick dip to the lower end of the trading range after continuous rising price movement may indicate that bulls are losing steam.
The stochastic oscillator, like other range-bound momentum oscillators such as the RSI and Williams%R, may be used to determine overbought or oversold circumstances. The stochastic oscillator, which has a range of 0 to 100, displays overbought situations with readings more than 80 and oversold conditions with readings less than 20. Crossovers in these extreme ranges are regarded very powerful signals. Crossover indications that do not occur at these extremes are often ignored by traders.
When developing a forex trading strategy based on the stochastic oscillator, seek for a currency pair that has a strong and long-lasting positive trend. The ideal currency pair has already been in overbought zone for some time, with price approaching a prior region of resistance. Watch for dwindling volume as another sign of bullish weariness.
When the stochastic oscillator passes over the signal line, price will follow. Though these combined signs are a strong predictor of an oncoming reversal, wait for price to confirm the decline before entering—momentum oscillators have been known to give false signals on occasion.
Using this setup in conjunction with candlestick charting methods may help to improve your approach and offer clear entry and exit signals.
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