The (Dumb) Formula You Need to Know About Stochastic Oscillators in Forex Trading

Technical analysis is used by most successful Forex traders, and amongst these are stochastic oscillators. They use technical analysis because they are unable to mentally identify trends and patterns due to the massive number of trades that occur in the Forex market. Almost a trillion dollars worth of volume is traded on this market daily… The only way to make sense of trends is very much to use technical analysis. This analysis will identify momentum in a currency using support and resistance levels. Amongst these, the most widely used momentum indicator types are the stochastic oscillators. Here are the top 3 things you need to know about Stochastic Oscillators in Forex trading.

1. This index was invented by Dr. George Lane in the 1950s. It is taken from the Greek term stochastic which means random. These momentum indicators measures the current price of a currency with its price range over a defined period of time. The goal is to predict the point in which the price of the currency will either increase or decrease by comparing it to is previous trading range.

2. Stochastic oscillators are calculated to find a range between a currency’s high price and its low price during the specified period of time. That period of time can be as short as a few hours or for a longer period of time like a month. The current closing price is compared to the price during the range to determine if you should be buying or selling at this point. This indicator will tell you when to enter or leave the market for maximum profit.

If the closing price of the currency consistently closes toward the higher end of the range, this will indicate buying pressure. On the other hand if it consistently closes toward the lower end of the range, this indicates selling pressure. Selling pressure is a sign of weakness. The formula for calculating one of the main stochastic oscillators is

%K = 100 * ((Closing Price – L) / (H-L)

where H and L are respectively the highest and the lowest price over the last n periods, and

%D = 3 period moving average of %K.

3. This index falls into three types – full, fast and slow. The original equation that was developed by Dr. Lane is now referred to as the fast indicator. This indicator was found to have a lot of volatility that resulted in generating too many flags that were not always accurate. The indicator has been modified and a fast and slow indicator has been created.

The slow index is used when smoothing the %K and %D lines. The formula is the same as the original type of stochastic oscillators except the two lines are smoothed. This removes the large number of flags that were created with the initial formula.

The full index indicates a new parameter to the original formula. This new parameter is the moving average of the %K line.

All in all it is not advisable to use stochastic oscillators alone – they are most profitable when used in conjunction with other types of technical analysis.

  • Simon Grimshaw
    #1 written by Simon Grimshaw 8 years ago

    Thanks for this. I’ve always struggled a bit with understanding wby Stochastics are used, but this post set it out in an easy-to-understand fashion. The point about not using any one indicator in isolation is very important though – I can attest to that! When I first started out I tended to only focus on one or two buy signals (typically Moving Averages or MACD’s), but I ended up at a net loss. Keep up the good work!

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