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How to trade ranges - Stochastic Oscillator

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Forex trading
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Lesson 8

The oscillators are probably one of the most ideal sets of indicators that help traders in ranging markets. Due to the sideways movement of price, it is often difficult for traders to pick the peaks and troughs.

However, the Stochastic oscillator can help those that move within fixed values.

Also known as the oversold and overbought levels, the oscillators can be useful when trading the sideways market. However, trading the ranging markets can be very risky as price can often strongly reverse. Winning trades can quickly turn into losing trades if the profits are not booked regularly.

Among the different types of oscillators available, the Stochastic is one of the most useful technical indicators when trading sideways markets.

Stochastic oscillator - the momentum indicator

The Stochastic oscillator was developed by George C. Lane. It is a momentum indicator. Momentum in technical analysis determines the speed at which price moves. Thus, when prices are rising and the momentum is strong, you can expect price to continue in that same direction.

When momentum starts to decline, you can then expect price to reverse or make a correction. The Stochastic oscillator was developed in the 1950s, and the indicator plots the values by comparing the current price to the price range over the determined period of time.

The Stochastic oscillator is made up of the %D and the %K values. Here, the %D is a three-day moving average of the %K, and the %K is based on the high and low range compared to price and the current low.

When the %K and the %D move across the fixed values of 80 and 20, and also crossover, buy and sell signals are formed.

Typically, the Stochastic oscillator reaching above 80 and turning lower signals momentum is slowing. Similarly, when the %K and the %D fall below 20 and turn higher, you can expect momentum to be rising.

Thus, combining the above information, traders can determine the rising and falling momentum in price.

The Stochastic oscillator is often referred to as fast and slow Stochastic, which indicates the settings. The fast Stochastic has values of 5, 3, 3, while the slow or full Stochastic has values of 14, 3, 3.

The only distinction between these two values is that the fast Stochastic is more sensitive to price action, while the full or slow Stochastic is slow to react and is ideally used in long-term analysis of the markets.

How to use the Stochastic Oscillator in Forex

The Stochastic oscillator is used in the forex market to determine the support and resistance levels. As these are one of the most important levels in determining price action, traders can use the oscillator and the support and resistance levels to determine the momentum.

Forex traders can also use the indicator to pick the turning points in the market based on where the value of the Stochastic oscillator sits.

The ideal settings for trading currency pairs are 5, 3, 3.

Overbought and Oversold levels

The Stochastic oscillator has the 80 and 20 levels as the overbought and oversold levels. When price falls from 80, sell signals are generated, and it suggests momentum is weakening. This means the previous direction of price could start to reverse or correct.

Similarly, when the Stochastic oscillator starts to rise from the 20 level, known as the oversold level, then momentum is beginning to rise.

In most cases, the Stochastic oscillator can signal a reversal only to fall back below the 20 level or rise and stay above the 80 level. Thus, it is essential for traders to trade not just with the oscillator. They should take into account the various market contexts and other indicators as well.

Stochastic range strategy

For the range strategy, the first step is to analyse the markets and identify potential support and resistance levels. This can be accomplished either by price action analysis or by using daily pivot points, plotted on the intraday charts.

Once the support and resistance levels are identified, the next step is to wait for the Stochastic oscillator to be overbought (above 80) and turn lower. Ideally, at this point, you should expect the price to be near a resistance level. You can then sell at the resistance and book profits based on your risk to reward set up.

Likewise, to go long in the markets, simply look for price at support and wait for the Stochastic oscillator to be oversold (below 20). Then, wait for the Stochastic oscillator to reverse at this level and go long in the market.

Stochastic Buy Signal

For intraday trading, it is ideal to use the 1-hour or 4-hour chart, where you can plot the support and resistance levels. The daily pivot levels can also be useful if you find it difficult to plot SR levels by yourself.

Stochastic Buy Signal

In the above example, we can see a Buy signal based on our range strategy. EURUSD is oversold (below 20), at the same time the currency pair is close to 1.1630 level. When price falls to the support level, the Stochastic oscillator reversed from the oversold level, we might buy EURUSD.

Stochastic Sell Signal

Stochastic Sell Signal

In the second example, we can see a Sell signal based on the stochastic range strategy. EURUSD is overbought (over 80), the pair is also close to resistance. When price starts to revers from 1.1730 level we might short EURUSD.

The Stochastic oscillator is a very versatile technical indicator that is easy to understand. However, traders should note that there are high risks when trading the ranging markets and simply using signals from the Stochastic oscillator is not good enough. To decide on your entry, you always need to consider the price action and upcoming events.

With practice and experience, traders can use the indicator to trade the sideways markets.