The Stochastic Oscillator is a momentum indicator that compares a currency pair’s closing price to the normal price range it has been displaying over a specified time period. The Stochastic Oscillator can has its sensitivity to market movements reduced or increased by adjusting the time period, or by taking a moving average of the result.

The idea behind the Stochastic Oscillator is that in an uptrend market, prices generally tend to close nearer to the high for the period, and during a downtrend market, prices will often tend to close near their low for the period. The indicator is often used in several different ways at one time as it is multi-faceted.

The first way traders will use this indicator is to trade like a moving average crossover system. In other words, when the quicker of the two moving averages crosses above the slower one, it is a buy signal. Of course, this works in the opposite direction as well. This shows the near-term momentum is building in one direction or the other.

Much like other oscillators, traders will often use the moving averages to determine whether there is likelihood of the currency pair being overbought or oversold as well. There are two lines, the 20 and the 80 that determine this. For example, if you are in a long position and see the Stochastics have the moving averages above the 80 line, you might be getting warned that the pair is now entering overbought territory. The same can be said for the averages dipping below the 20, as it signals oversold conditions.

The Stochastic Oscillator can also determine divergence as well. Generally speaking, when a pair is making new highs, you want to see the averages on the oscillator doing the same thing. If not, you have divergence and a possibly weak undercurrent to the recent surge upward. This works in reverse as well, as a failure to make new lows suggests that there isn’t as much selling conviction in the marketplace as the new lows have been made.

Published on 17th of June 2011
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