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The Stochastic Oscillating Indicator

Sound familiar? You have spent years surfing the 'Net, and studying books and charts in search of currency trading strategies or forex trading strategies. All you really want is the 'Holy Grail' of entry techniques. You usually end up adding one indicator on top of another, switching from one guru to the next, until you are so confused and unsure of your entry system that you are unable to make entry decisions and stay organized. You get so distracted and frustrated that you quit watching the markets all together!

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The Stochastic Oscillating Indicator

Originally conceived by George Lane (a physician) in the 70s for the commodity futures markets, this indicator lets you know where closing price is in relation to the trading range of the underlying market – i.e., whether it is overbought or oversold – between readings of zero and 100.

The stochastic indicator serves to identify probable trend change in trending markets. It works under the assumption that the trend is reaching its end in an up market, when price begins closing consistently more towards the lows of the time period and trading range. Conversely, it assumes that, in a down market, the trend will reverse as the closes tend to be more towards the highs.

Market peaks and bottoms are coincident with readings of above the 70-to-80 level for market tops (overbought) and below the 20-to-30 level (oversold) for the bottoms. This particular indicator gives guidance when the underlying market reaches these extreme levels. Just about every charting package out there offers this feature.

An ‘overbought’ situation occurs when the market has been pushed up by an influx of buyers. Eventually, after buyers have eaten too much chocolate, sellers take profits, and prices begin to fall. Should price declines force the stochastic indicator below 30, this would indicate an ‘oversold’ condition. In this case, an influx of sellers has caused the market to swoon.

The stochastic indicator consists of two lines: a red solid %K line, the faster line, with a five-day range and no slowing, and a blue broken %D (signal) line, the slower line, which is a three-day simple moving average of %K. The two black horizontal lines delineate overbought and oversold levels at values 80 and 20 respectively.

In order to use stochastic effectively with your toolbox of currency trading strategies (a.k.a. forex trading strategies), you should observe George Lane’s original intention behind stochastic.

Note: George Lane, the creator of this indicator, opined that divergence is the only valid signal on which to trade. According to him, a valid signal occurs only when divergence between price and stochastic is followed by a crossing of the %K and %D lines.

Here are four types of divergence:

1. (Bearish, higher price highs with correspondingly lower stochastic highs) - The market moves higher, but stochastic suggests a slowing trend. This is reflected in higher price highs and lower stochastic highs, and is a sure sign that a price correction is not far off.
   
2. (Bullish, lower price lows with correspondingly higher stochastic lows) - The lower lows in price action show a divergence with higher stochastic lows. As stochastic shows the market becoming less oversold, the market itself fails to confirm this notion and continues on down. However, this is just indicative that price will invariably shift course and follow stochastic’s lead.
   
3. (Bullish, lower price highs with correspondingly higher stochastic highs) - In a down-trending market, changes in price establish lower price highs, all the while stochastic reflects the market becoming less oversold (higher stochastic highs), signaling a likely reversal in the works.
   
4. (Bullish, higher price lows with correspondingly lower stochastic lows) - As price achieves higher lows, stochastic reflects a last ditch effort on the part of sellers to continue the downtrend (lower stochastic lows). This exhaustion, combined with new buying pressure, as reflected in upward price direction, portends the potential reversal of the downtrend.

You can apply these observations to any timeframe. Sometimes, a particular timeframe will display one of the above characteristics more so than the others. The higher the timeframe, the better the chance for a longer-term trend reversal. It is important when looking at lesser timeframe charts to keep the big picture in mind. A divergence between price behavior and stochastic movement on a five minute chart may provide only a relatively short period of change in the attitude of price.

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