Stochastic indicator that many investors use in Forex trading? What is the difference between the RSI indicator and the Stochastic RSI? The article below will help readers answer the above questions, as well as have a deeper look at this potential trading tool. Let’s consult Forex Trading now.
What is the Stochastic indicator?
The Stochastic indicator is a technical analysis tool and belongs to the group of momentum oscillators (which includes TRIX, RSI, and MACD). Through this tool, investors can establish overbought or oversold conditions in the Forex market.
Stochastics was developed in the 1950s and is used to assess the momentum of asset prices, and the overall strength of market trends. Stochastic allows traders to see trend strength and momentum. In addition, this indicator also gives a warning about the possibility of a reversal. Therefore, Stochastic is considered a convenient tool in all market conditions, helping traders identify potential trading opportunities.
What does the Stochastic indicator include?
In terms of structure, Stochastic Oscillator includes the following components:
- Oscillating line %K: This is the main oscillating line, located quite close to the price range and colored blue.
- Oscillating line %D: This is a moving average, calculated according to SMA 3 of the %K line, and is orange. This line has a certain delay compared to the %K line.
- Border: By default, the lower border is 20 and the upper border is 80.
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Distinguish between RSI and Stochastic RSI
Stochastic RSI can predict market price reversals and identify divergences similar to the Rsi divergence strategy. To distinguish the difference between these two indicators, you need to understand Stochastic RSI and what is rsi index.
Stochastic RSI is a technical indicator that helps traders identify overbought and oversold levels and measure market developments. This indicator has become popular since 1994, used for the purpose of analyzing and evaluating asset price trends. Basically, Stochastic RSI is similar to Stochastic Oscillator but can provide more sensitive and more accurate signals.
RSI is a technical analysis indicator that helps investors measure price changes over a fixed period of time. Thanks to that, evaluate the overbought and oversold conditions of the asset. This indicator has a slower moving speed than Stochastic RSI. Besides, the signals generated by RSI are also small signals and have less quantity than Stochastic RSI.
Formula to calculate the value of the Stochastic indicator
To calculate the oscillating lines of the Stochastic indicator, you apply the following formula:
- %K = (C – L14) / (H14 – L14) * 100
- %D = (current %K + previous trading period %K + 2 previous trading periods %K) / 3
In there:
- %K: Current value of Stochastic Oscillator.
- %D: Moving average.
- C: Closing price at the current time.
- H14: Highest price in the last 14 periods.
- L14: Lowest price in the last 14 periods.
Analyze what role Stochastic plays in trading
By using Stochastic, investors can identify reversal and divergence signals, as well as observe price changes and find oversold/overbought areas accurately and quickly.
The Stochastic indicator identifies oversold and overbought areas
Stochastic Oscillator scales between 0 – 100. Based on the two oscillating lines %K and %D, combined with the borders 20 (lower border) and 80 (upper border), traders can Overbought and oversold zones can be determined as follows:
- In case the indicator is below the 20 border, it means the price action is in an oversold state.
- On the contrary, if the Stochastic Oscillator is above the 80 borders, it means the market price is in an overbought state.
After identifying the overbought and oversold areas, place an order when you notice that the price is oversold when the market is trending up, and overbought in a downtrend.
Identify trends through Stochastic
In case the market is trending up and the price action breaks out of the range under consideration, the Stochastic Oscillator will move upward. On the contrary, with a downtrend, the price action tends to go down relative to the range under consideration. At this time, the Stochastic Oscillator will point downward.
However, if you want to evaluate the trend more accurately and effectively, you can combine this indicator with other tools (trendline) or time frame analysis.
Divergence and reversal signals in technical analysis
Stochastic oscillators can give divergence signals like the RSI technical indicator divergence. Thereby, helping investors identify potential reversal points to conduct transactions. You can consider two cases: Bullish divergence and bearish divergence.
- A bullish divergence occurs when the price creates a new low that is lower than the old low. However, the Stochastic Oscillator created a higher bottom. This shows that market prices are decreasing slowly. This is also a sign of a reversal, the price will increase again.
- A bearish divergence occurs when the price creates a new peak that is higher than the old peak. Meanwhile, the Stochastic indicator created a lower peak. This shows that prices are increasing slowly. This is a signal that the price will reverse from increasing to decreasing.
How to use the Stochastic indicator in Forex
In Stochastic Oscillator, a crossover signal appears when two lines intersect in the overbought/oversold zone. A sell signal occurs when %K falls below %D in the overbought zone. Meanwhile, a buy signal appears when %K increases above %D in the oversold area.
Use candlestick and Stochastic patterns
In Forex trading, you can combine this oscillator with candlestick patterns. Thus, you will have a very effective set of signal-filtering tools, increasing the probability of success when making transactions. You need to note the following rules if using the reversal candlestick pattern:
- Clearly identify the market trend at the present time.
- Search and identify areas where reversal candlestick patterns appear (Hammer, Morning Star, Bullish Engulfing,…).
- Identify overbought and oversold areas through the Stochastic Oscillator.
Combine Stochastic indicator with trendline
When combined with the trendline, Stochastic acts as a filter to confirm buying and selling signals. Some rules traders need to follow when combining these technical tools:
- Identify price trends on high time frames.
- Do not trade against the market trend.
- Apply the intersection point between %K and %D at the oversold/overbought area to determine the entry point.
A buy signal appears when the market price touches the rising trendline, and %K cuts %D below 20%. The sell signal appears when the price touches the downtrend line, and %K crosses the %D line above 80%.
Apply Stochastic, Bollinger bands in technical analysis
Unlike Stochastics, which is used as a signal filter, Bollinger bands are a technical analysis tool that helps investors identify support and resistance levels. Applying these two tools in Forex trading, a buy signal will appear when a bar crosses (or touches) the lower boundary of the Bollinger band. At the same time, the %K line cuts the %D line from bottom to top and below 20%.
Conversely, a sell signal occurs when a bar crosses (or touches) the top line of the Bollinger band. At the same time, %K crosses the %D line above 80%.
Combine Stochastic indicator and MA line
Applying a Stochastic Oscillator and MA lines is a simple trading strategy. Through the 200 MA and daily time frame, traders can identify long-term trends.
- In case the uptrend is maintained long-term, the market price will always remain above MA 200. You can consider MA 200 as a dynamic support level.
- On the contrary, with a long-term downtrend, prices always maintain movement below the MA 200.
A buy signal occurs when the price is above MA 200 and Stochastic enters the oversold area. A sell signal occurs when the price is above MA 200 and Stochastic enters the overbought area.
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Conclude
The stochastic indicator is an effective technical analysis tool that traders should not ignore when conducting Forex trading. Hopefully, through the above sharing, readers will have more useful information about how to apply this indicator. Don’t forget to visit Forex Trading to read in-depth articles about the Forex market.
FAQs
Here are a few frequently asked questions when traders use the Stochastic oscillator.
Should a Stochastic Oscillator be applied at low time frames?
Low time frames often appear as false signals, and price traps, causing the indicator to become noisy. Using a Stochastic Oscillator in low time frames will make it difficult for traders to accurately identify trends and trading signals.
How effective is using the Stochastic oscillator alone?
If you only rely on Stochastic to determine buy and sell signals and place orders, the risk is quite large. Therefore, you should not use this indicator alone. To increase the accuracy and efficiency of trading, traders are required to combine it with other technical indicators.
Can Stochastic RSI be used to determine short-term trends?
You can use Stochastic RSI to find short-term trends. If this indicator has a value above the 50 center line then the price is trending up. If Stochastic RSI has a value below 50, the price tends to decrease.
