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Stochastics is a technical momentum indicator propounded by George Lane in the 1950s. It measures the price of a currency pair relative to the high/low range over a period of time. In other words, it compares a currency's closing price to its price range over a given time period. The basic principle of Stochastics is that when a currency is in uptrend i.e. bull run it tends to close near its previous highs and when it is in downtrend, it closes near it lows.
Being an oscillator, its value moves between 0 and 100, with 20 and 80 being the oversold and above overbought lines respectively. Hence, if the value falls below 20, it suggests that the currency is oversold, and vice versa. The area above and below these lines are referred to as the Stochastic bands. The oscillator's sensitivity to market movements can be reduced by increasing the time period, although stochastics typically work best with monthly charts.
Stochastics also consists of two lines known as the %K, the fast line and %D, the slow line. The %K can be called the fast moving average whereas the %D line can be called the slow moving average. The %D is the signal line, calculated by smoothing the %K line.
Some key points to remember are:
• The %K line is more sensitive than the %D line
• The %D line is a moving average of the %K line
• The % D line is the one that generates trading signals
Significance
The primary application of stochastics is to determine whether there is strength or weakness in the market, and consequentely ‘bullishness’ or ‘bearishness’ respectively. It is rather effective in predicting major market ‘turns’ or ‘reversals’ well before they actually happen.
Signals
1. Crossover between the %D and %K lines: Buy when the %K line rises above the %D line and sell when the %K line falls below the %D line. Beware of short term crossovers or ‘whipsaws’. Crossovers often provide choppy signals that need to be evaluated with other indicators.
2. Divergence in the stochastic and the market price: For example, if prices are making a series of new highs and the stochastic is tending lower, you may have a warning signal of weakness in the market.
3. Extreme values when the 20% and 80% trigger lines are crossed: Buy when the stochastic falls below 20% and then rises above that level. Sell when the stochastic rises above 80% and then falls below that level.
Advantages
Stochastics are very useful for short term trading, particularly ‘swing trading’. It is a leading indicator and can provide excellent signals very early on.
Drawbacks
Don’t be fooled by ‘whipsaws’, where the stochastic temporarily moves above or below the signal line and then returns quickly, thereby catching the investor off guard and trapping them. Furthermore, it often occurs that the stochastic gets ‘stuck’ in the overbought or oversold zone, without moving out and thereby trapping a trader indefinitely.
Key Takeaways
Stochastics is a leading indicator for the forex market, an oscillator which moves between 0% and 100%, with 20% and below suggesting oversold and 80% and above suggesting overbought, with each representing a potential bull run and bear run respectively. However, stochastics should be used with care, especially with ‘whipsaws’ and consolidation trends.| Ready to start trading? Beginner traders may appreciate all that Plus500 has to offer, while intermediate or advanced traders will likely love the choice of trading platforms offered by Markets.com. Read our reviews of the top-rated Forex brokers such as our FXCM review or our AvaFX review to find the right broker for your needs. |
