How to Trade Forex with the Stochastic Indicator

The Stochastic is an Oscillator that is typically used to identify overbought and oversold conditions in your day trading.. The indicator consists of two lines: % K and %D. These two lines fluctuate in a vertical range between 0 and 100. Readings above 80 are considered overbought and readings below 20 are considered oversold.

Many traders use Stochastics to generate buy and sell signals. When the faster %K line crosses above the slower %D line and the lines previously crossed below 20, a buy signal is generated. When the %K lines crosses below the %D line and the lines previously crossed above 80 a sell signal is generated.

After identifying a trend it possible to identify buy and sell opportunities. If the trend is up as on the eur/usd daily chart below then we take only buy signals as long as the trend remains in place. We ignore the sell signals and weaken the stochastic by changing the settings to 5,3,3 which will generate more signals and show the hand of the weaker players in the market.

On its own the stochastic generates too many false signals and plenty of whipsaw which can lead to losses.

As we can see from the above daily chart the eur/usd continued its uptrend from 21 August 2007 until 11 November 2007 a rally of 1400 pips before consolidating in a 500 pip range. The next breakout occurred as a continuation on 26 Feb 2008 rallying another 1400 pips before consolidating again.

As with all lagging indicators they are best used in conjunction with other indicators. The large highlighted trade shows a buy signal on the stochastic with the market dropping 300 pips. Stop losses should be placed below the last low or high. All the other signals produced good trades.

By using a 4 hr chart we can probably get better entries with tighter stops once we have a confirmed signal on the daily time frame.