Stochastics

A. Trading With Stochastics

What is stochastic?
Stochastic is an oscillator that works well in range-bound markets.

What it does. Stochastic is an oscillator – meaning it offers a measurement of the deviance of currency pair’s rate (price) from its normal levels. Like all oscillators, stochastic offers indications of when a currency pair is overbought/oversold. Accordingly, it works well in markets that are not trending, but rather just fluctuating back and forth between an upper level (resistance) and a lower level (support).
Parameters. Stochastic typically has three parameters that users must specify: %K, %D, and number of periods. Here is one commonly used setting for those parameters:
· 5 for %K
· 5 for %D
· 3 for number of periods
%K is the fast moving line; it measures the relative strength of the asset, like RSI. %D is a moving average of %K, and hence is a much slower line.

Different Inputs. The fast stochastic only requires two inputs, which are normally 5 and 5. The slow stochastic requires a third input, which is the number of periods used in taking a moving average of the fast %D line. Unlike MACD (which commonly uses 12, 26, and 9) or RSI (which uses 14), Slow stochastic has a number of popular settings that can be used. 5, 3, and 8 is one commonly used setting. 15, 3, 3 is used by conservative traders who are interested in receiving less signals, while 8, 5, 5 and 5, 5, 3 are more aggressive settings for traders who are looking for fast signals. The tradeoff between accuracy and speed is something every trader must consider when choosing the inputs they will use in stochastics.
How to Use Stochastic in Currency Trading

· Can be used to determine overbought/oversold levels, like RSI
· Can be used in a crossover fashion like moving averages
· Used to spot divergences, which indicate potential weaknesses in trends

Crossover. When %K crosses %D (when fast crosses slow), it can be interpreted as a trade opportunity. Traders can enter positions following the direction of %K.

Overbought/Oversold. Look for both %K and %D to be above/below the 20/80 levels. If they are both above 80, it may be a good opportunity to sell, as the asset is overbought and expected to return back to a normal level. Alternatively, if it is below 20, the asset is oversold – and hence it may be a prime buying opportunity, as a range-bound market would imply that the currency pair will head back to a more “normal” asset price.

Divergence. Stochastic can also be used to determine when NOT to enter a position. For instance, if a trend looks strong, traders can look to stochastic to see if there is any divergence between the movement of the asset and the stochastic lines. If, for example, a currency pair is headed upwards sharply and is making new highs, but the stochastic is not making new highs or even heading downwards, then this suggests that the trend is weak, and the prices may come back down. Conservative traders can use look for divergence as a caution not to enter a trade based on momentum, while more aggressive traders can use divergence as a signal to enter a position before the trend actually starts retracing.

Slow versus Fast Stochastic. There are two types of stochastic, slow and fast. Both display the same two lines, and both can be interpreted in the same manner for crossovers, overbought/oversold conditions, and divergence. The difference is that the %D line of the slow stochastic is smoothed out by taking a moving average of the %D line of the fast stochastic. This makes the slow stochastic more accurate in the trade signals it provides but somewhat slower to react to the changing market price.

B. Stochastic: Historical Trades
Below are two examples of how stochastic could have been used to place a profitable trade. Note that the first chart uses crossovers for signals while the second chart uses divergence. Since divergence is not a precise indicator in terms of timing, the double top can be used for an entry point.