This week, as promised, I’m going to talk about two indicators that don’t seem to get a lot of attention lately (at least from what I can see), and the one I’m going to start with is the Stochastic Oscillator. Now, what is the Stochastic Oscillator? According to Investopedia, is an indicator that measures the relationship between a financial instrument’s closing price and its price range over a defined period of time. It was developed by Dr. George Lane, who was a securities trader, author, educator, and technical analyst. It’s been around a while, and is worthy of consideration for those of us trading Forex today.
The premise of the stochastic oscillator is that a financial instrument’s price action tends to close near the extremes of the recent range before turning points. So, how do we make a practical application of using the stochastic indicator? Let’s take a look at the chart below:
This is a four hour chart of USD/JPY. The lower part of the chart is the stochastic oscillator, and the horizontal dotted lines represent the 20 and 80 levels (20 being the lower line, and 80 the upper line). The stochastic oscillator has two signal lines, K (fast) and D (slow) moving within a fixed range of 0 to 100, and is usually used in the context of signaling an overbought condition in the market when the signal lines of the oscillator are above the 80 line, and conversely, signaling and oversold condition in the market when the signal lines or below the 20 line. Additionally, we see on this chart 2 moving averages: A 12 EMA (red) and a 26 EMA (blue). On the left side of the chart we see the stochastic indicator signal lines breaking the 80 level (top dotted line) and, about five or six candles later, price action takes a steep nosedive. In this example that’s about 200 pips (remember this is a four hour chart, I tend to be biased towards using this indicator on longer time frames). Do you notice also that slightly afterwards, the signal lines on the stochastic oscillator start heading upwards, but never quite makes it to the 80 line? Price action heads up briefly but then quickly reverses and moves down very strongly. This a subtle clue about this reversal reflected in the behavior of the signal lines themselves which I will mention in a bit.
This chart ends with the stochastic oscillator ending up in oversold territory (below the 20 line). Let’s look at a continuation of this chart:
Okay, so we now have the stochastic oscillator below the 20 line (lower center of chart), followed by an uptick in the price action for about five candles (about 70 pips over the next 24 hours), followed by the stochastic oscillator showing an overbought condition (above the 80 line), followed by continued downward movement. In the example shown the market is in a strong downward trend as exemplified by the 12 EMA (red line) below the 26 EMA and both slanting downwards strongly. So it will be prudent if one was trading this chart to stick with short positions when the stochastic indicator were showing overbought condition. Also pay attention to the signal lines themselves – when the fast line (sea green) is above the slow line (dotted red) price is going up, and when the fast line is below the slow line, price is going down. This is important to note if you see a cross of the signal lines (such as in the lower center of this chart) you get a hint of reversal before the signal lines cross the 20 line. This is the subtle clue that I was alluding to earlier.
Now this particular snippet of chart ends with the stochastic oscillator just about touching the 20 line. What do you think the market is going to go next? If you want to find out, and learn about the other mystery indicator, you will have to stay tuned for part two of this article and go find out!
Until then have a great week and good luck in the market! JC