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How Does Stochastic Indicator Work in Forex Trading?

Stochastic Indicator is used in Forex to identify overbought and oversold market conditions that substantially lead to market reversals. It becomes easier for traders to determine when and where to enter or exit the market when they receive potential market reversal signals through the Stochastic Indicator. In this article, we discuss everything there is to know about Stochastic Indicator:

What is a Stochastic Indicator?

Stochastic Indicator measures the market's price momentum. The indicator uses support and resistance levels to determine when a currency pair is trading above or below its actual/fair value. The indicator is a range bound and consists of readings between 0 to 100. It helps compare how far or close the current currency pair price is trading to its high and low price levels. This leads to future market price predictions that help traders enter or exit the market.

  • Traders receive buy signals whenever the current price is close to its low price, as the market is expected to reverse in an upward direction from hereon
  • Traders receive sell signals whenever the current price is close to its high price, as the market is expected to reverse in a downward direction from hereon

Types of Stochastic Indicators

1. High Stochastic

A High Stochastic occurs when the currency pair prices close near its high price and keep increasing. An overbought condition is signalled when the stochastic lines are above 80, providing traders with a downward market reversal. This prepares traders to short the trade with the prices expected to fall soon.

2. Low Stochastic

A Low Stochastic occurs when the currency pair prices close near its low price and keep decreasing. An oversold condition is signalled when the stochastic lines are below 20, providing traders with an upward market reversal. This prepares traders to enter long trade positions, with the prices expected to increase soon.

Stochastic Indicator graphic

What is the Stochastic Indicator formula?

The Stochastic Indicator consists of two lines — K and D. The K line is used to compare the lowest of the low and highest of the high price levels of a currency pair in the last 14 periods (days, weeks, months or an intraday time period), to define the currency pair’s price range. After the price range is defined, it displays the last closing price percentage of the range.

  • A higher percentage shows that the closing price is near to the high price, signalling an overbought market condition
  • A lower percentage shows that the closing price is near to the low price, signalling an oversold market condition

The D line is the 3-period simple moving average of K, and it helps in smoothing out the trendlines that generate trade signals. Calculating K = 100 * (CP – L14 / H14 – L14) Where,
CP = Recent closing price
L14 = Lowest price of the previous 14 trading periods
H14 = Highest price of the previous 14 trading period

Calculating D = 100 * (H3/L3) or 3-day simple moving average of K Where,
H3 = Highest price in the last three trading sessions
L3 = Lowest price in the last three trading sessions

Stochastic Indicator graphic

Benefits of trading with the Stochastic Indicator

1. Provides strong market turning points

The Stochastic Indicator predicts market turning points or reversals by comparing a currency pair’s current closing price with its price range. If the prices close near the high or low price in the range, it signals a market reversal.

  • If the currency pair is trending in the upward direction, its closing price will be nearer to the high price, signalling a downward market turning point
  • If the currency pair is trading in the downward direction, its closing price will be nearer to the low price, signalling an upward market turning point
2. Helps traders time their entries better

The Stochastic Indicator helps traders time their entries as it provides them with potential signals as to when an uptrend will end in the overbought market and when a downtrend will end in the oversold market.

  • If you want to enter a long trade, it is recommended to enter the market when the Stochastic line crosses above the level of 20
  • If you want to enter a short trade, it is recommended to enter the market when the Stochastic line crosses below the level of 80
Stochastic Indicator graphic
3. Filters high probability trading setups

High probability trading setups are in the same direction as the overall currency pair price trend. Filtering high probability trading setups requires a trader to trade in a longer timeframe, with the market direction and not against it.

  • When a market is in an uptrend, it sends a buy signal to traders
  • When a market is in a downtrend, it sends a sell signal to traders

The Stochastic Indicator can be used to filter short-term trades by considering the currency pair’s long term positioning.

How to trade with the Stochastic Indicator

Trading with the Stochastic Indicator completely depends on where the stochastic lines are trending. If it is trending above 80 and indicating an overbought market condition, traders are signalled to exit the market. If it is trending below 20 and indicating an oversold market condition, traders are signalled to enter the market. Let us understand this with an example. If EUR/USD’s price range is 1.2-2.5, with 2.5 being the highest price in that period, and its current price closes at 2.3, it shows an overbought market situation and signals traders to exit the market as soon as possible. On the other hand, if the same pair closes at 1.4 (which is closer to its lowest price of 1.2), it shows an oversold market situation and signals traders to enter the market as soon as possible.

How to trade with the Stochastic Indicator

Stochastic Indicator helps traders understand when a market is overbought or oversold and make trade decisions accordingly. Trading with Blueberry Markets, you get a reliable trading experience with the help of readily accessible strategies and charts. Sign up for a live trading account or try a risk-free demo account on Blueberry Markets.

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