What Is The Stochastic Indicator? How To Trade Forex Effectively With Stochastic

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What Is The Stochastic Indicator? How To Trade Forex Effectively With Stochastic

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It is one of the most effective tools in predicting price trends. That’s how investors talk about the Stochastic indicator in Forex technical analysis. So what is a Stochastic indicator? How to use it in Forex trading effectively? In today’s article, I will help you understand this.

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What is a Stochastic indicator?

The Stochastic Oscillator (aka Stochastic) is a momentum indicator. This indicator compares the closing price to a specific price range over a given period of time. Momentum is a quantity that precedes prices. That’s why Stochastic always gives users signals with very high accuracy. This is also the biggest advantage of this indicator.

What is a Stochastic indicator?
What is a Stochastic indicator?

The Stochastic indicator consists of 2 main elements:

The 1st element is a fixed line:

+ Upper line (green): Overbought zone (80).

+ Lower line (red): Oversold zone (20).

The 2nd element is a movable line:

+ Light blue line (%K line): aka main line. It shows how the price reacts to the momentum.

+ Red line (%D line): aka Stochastic’s moving average.

How to use the Stochastic indicator

In Forex trading, the Stochastic indicator is for predicting price trends. The basic operating principle of this indicator is that when prices change, the momentum must change accordingly.

Strategy 1. Use Stochastic to find market trends.

The Stochastic indicator ranges from 0 to 100. It takes 80 and 20 zones as overbought and oversold zones respectively.

Use Stochastic to find market trends
Use Stochastic to find market trends

+ In periods (2) and (4), the Stochastic indicator points up from the oversold zone (20) to the overbought zone (80). At the same time, the blue line (%K) stays above the red line (%D). The price is in an uptrend.

+ In periods (1) and (3), the Stochastic indicator heads down from the overbought zone (80) to the oversold zone (20). At the same time, the blue line (%K) falls below the red line (%D). The price is in a downtrend.

Strategy 2. Using the Stochastic divergence to recognize the trend reversal

Stochastic divergence is a phenomenon in which an indicator reacts against price behavior.

Details are as follows:

Stochastic bullish divergence appears when prices are in a downtrend. The price creates 2 troughs of which the following trough is lower (or equal) to the previous trough. However, Stochastic signals an uptrend. After this signal, the price will be more likely to reverse from bearish to bullish.

Stochastic bullish divergence occurs when the price is in a downtrend
Stochastic bullish divergence occurs when the price is in a downtrend

Stochastic bearish divergence appears when prices are in an uptrend. The price creates 2 peaks of which the following peak is higher (or equal) to the previous peak. However, Stochastic signals a downtrend. After this signal, the price will be more likely to reverse from bullish to bearish.

Stochastic bearish divergence occurs when the price is in an uptrend
Stochastic bearish divergence occurs when the price is in an uptrend

How to effectively trade Forex using the Stochastic indicator

There are many ways to open a Forex order with Stochastic indicator. However, to maximize profits and minimize risks for your transaction, you need to identify your take-profit and stop-loss points. I will guide you through this in detail.

*Notes: The following strategies to open an order should only be done with a Demo account. These are test transactions to get you familiar with as well as test the effectiveness of the Stochastic indicator. Absolutely do not apply it on a real account.

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Strategy 1: Open Forex orders according to Stochastic overbought – oversold signals

This trading strategy is very simple and does not require you much patience to open an order.

Conditions: A 30-minute or 1-hour Japanese candlestick chart & Stochastic indicator.

Open a BUY order as follows:

+ Entry Point: Right after the %K line (green) cuts the %D line (red) from below and expands in the oversold zone. At the same time, the Stochastic points up.

+ Stop-Loss: At the lowest price level before rebounding.

+ Take-Profit: We take profit when the %K line crosses the %D line from above at the overbought zone.

Open Forex orders according to Stochastic overbought - oversold signals
Open Forex orders according to Stochastic overbought – oversold signals

Open a SELL order as follows:

+ Entry Point: Right after the %K line (green) cuts the %D line (red) from above and expands in the overbought zone. At the same time, the Stochastic heads down.

+ Stop-Loss: At the highest price level before falling back.

+ Take-Profit: We take profit when the %K line crosses the %D line from below at the oversold zone.

Open Forex orders according to Stochastic overbought - oversold signals
Open Forex orders according to Stochastic overbought – oversold signals

Strategy 2. Trade using the Stochastic divergence

Stochastic divergence is a very good signal for you to enter a trade. However, the limitation of this strategy is that you have to wait patiently. This is because the Stochastic divergence rarely appears.

When the Stochastic bullish divergence appears, open a BUY order as follows:

+ Entry Point: Right after the %K line cuts the %D line from below. There, the price finishes creating the lower trough and starts rising again.

+ Stop-Loss: At the lowest price level before the Stochastic bullish divergence appears.

+ Take-Profit: We take profit when the %K line crosses the %D line from above at the overbought zone

Trade Forex using the Stochastic divergence
Trade Forex using the Stochastic divergence

When the Stochastic bearish divergence appears, open a SELL order as follows:

+ Entry Point: Right after the %K line cuts the %D line from above. There, the price finishes creating the higher peak and starts falling again.

+ Stop-Loss: At the highest price level before the Stochastic bearish divergence appears.

+ Take-Profit: We take profit when the %K line crosses the %D line from below at the oversold zone.

Trade Forex using the Stochastic divergence
Trade Forex using the Stochastic divergence

Notes to know when using Stochastic indicator in Forex

+ The Stochastic indicator is a trend indicator. Therefore, you should use it to look for short-term reversal transactions. This will be very risky for your transaction.

+ To increase efficiency, you can combine Stochastic with other analytical indicators.

+ Stochastic is most effective when the market does not fluctuate too strongly or there is no news.

Now you have the knowledge. It is time to test the Stochastic indicator directly on a Forex Demo account. I wish you successful transactions.

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