Stochastic Oscillator consists of two lines that oscillate between a vertical scale of 0 to 100. %K is the main line. It is moving faster that %D line. %D line is the second line and is a moving average of %K.

Stochastic works better in broad trading ranges or in a mild trend with a slight upward or downward bias. The worst market for normal use of stochastic is a persistent trending market that has only minor corrections. Although, one could trade stochastic by ignoring the usual overbought and oversold levels and entering the market when the end of a reaction against the trend is signaled by a crossover from any level.

There are three ways to interpret the Stochastic Oscillator:

1)Buy when the oscillator (%K or %D) falls below 20 and then rises back above that level. Sell when oscillator rises above 80 and then falls below that level. Extra caution: If the oscillator reaches the extremes of the scale it should not be interpreted that the currency will necessarily reverse in the immediate future. It will indeed reverse but it may be between the next day and several days after. Unfortunately with stochastic it is impossible to know the time interval between the signal appearance and the price reversal.

2)Buy when the %K line rises above the %D line and sell when the %K line falls below the %D line. (crossovers)

2)Look for the classic divergences, that is prices making new highs as the stochastic oscillator fails to surpass the previous highs.

Slow stochastic oscillator is using a technique to smooth the lines reaction in an attempt to reduce volatility and improve signal accuracy. This oscillator is most popular among traders because it provides less but more accurate trading signals.

Illustration of stochastic oversold level and crossover

Illustration of stochastic divergence

This entry was posted on Monday, March 26th, 2007 at 6:13 am and is filed under Technical Indicators. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.