Large volumes of currencies pass through the Forex market every day. The currency pairs usually move in small increments and often remain in certain limits called the trading range. Forex traders use this in a forex trading strategy called the Stochastic Oscillator. The idea is somewhat similar to Bollinger bands, namely, once the market reaches the overbought or oversold position, it will return back to the mean position. This strategy is relatively easy and can be used by the beginners of forex as well as by the professional traders. However, the exact time when the curve begins its movement to the original position requires some simple math.
The Stochastic Oscillator is a tool to measure this position using the recent highs and lows over a prescribed period of time, on a scale of 0 – 100. Positions greater than 80 are considered to be overbought whereas levels below 20 are considered to be oversold. The positions between 20 and 80 are considered to be normal and therefore no trade signal is implied.
Furthermore, the Stochastic Oscillator shows the traders when the price reaches the border of its trade range within the prescribed period of time. It displays 2 curves the fast (%K) and the slow (%D) . %K is a ratio of the difference between the latest closing price and the lowest low to the recent trading range (the Ndays highest high minus the Ndays lowest low). If the latest closing price is equal to the lowest low, the ratio is equal to zero. If it is equal to the highest high, the ratio is equal to one hundred. The slow curve %D is a 3-day simple moving average of %K
A buy signal occurs when the one or both stochastic lines cross below ‘20’ and then shows signs of a reversal as the lines cross one another while remaining below the 20 level. To wait for further confirmation wait for both stochastic lines to cross back above 20. Conversely, sell when the oscillator rises above the overbought level and then falls back below that level.
Note that these techniques perform the best when used to isolate extreme market conditions, where a reversal to the center is likely. Finally, forex traders should disregard the indicators when the stochastic curves are between the 20 and the 80 level.
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