Oscillators are repetitive actions that move (or oscillate) above and below an equilibrium, and are used by analysts to provide insight into potential future market direction.
IDENTIFYING MARKET TRENDS
Stochastic is a Greek word meaning "guess" or "random". The Stochastic Oscillator uses a scale to measure the degree of change between prices from one closing period to predict the continuation of the current direction trend. It is based on the following premise:
1. During a market uptrend prices will remain equal to, or above the previous period closing price.
2. Conversely, in a market downtrend prices will likely remain equal to, or below the previous closing price.
The Stochastic Oscillator consists of two lines. When both lines are included on a price chart, it is referred to as the full stochastic. The two lines are:
1. %K, also known as “stochastic fast”, tracks the current market rate for the currency pair.
2. %D, known as the signal line, typically uses the last three valuations of %K to create a moving average of the %K stochastic. Because %D is a moving average of %K, it is referred to as "stochastic slow"since it reacts more slowly to market price changes than %K.
Trading platforms perform the calculation based on the formulas below. Note that N is usually is set to 14 periods to represent a large enough sample of data to arrive at a meaningful calculation. You can modify the number of reporting periods on the OANDA platform, but this could alter the effectiveness of the results.
%K = 100 x (Closing Price - Lowest Price of N Periods) / (Highest Price of N Periods - Lowest Price of N Periods)
%D = 3 – Period Moving Average of %K
A crossover occurs when the fast stochastic (%K line) intersects the slow stochastic (%D line). Because the %K line reacts more quickly to market changes it oscillates at a faster rate than the %D line. Under certain conditions, it can catch up to, and cross over the %D line.
When the %K Stochastic crosses over and moves above the %D Stochastic, the interpretation is that the market rate is gaining at a faster rate than the average represented by the %D Stochastic. This increase in price strength is considered a buy signal.
A sell signal is the result of the %K Stochastic crossing under the %D Stochastic because the faster moving %K line is declining more rapidly than the overall downward trend.
Some traders pay close attention to the 50-level crossover that occurs when the %K Stochastic crosses the 50 line on the scale, which is seen as movement toward a stronger position and interpreted as a buy signal. When the %K line crosses under the 50 level, the exchange rate is said to be weakening and is a sign to sell the currency pair
Divergence arises when the direction of an asset’s price moves opposite to one of several indicators, including an oscillator. A positive divergence occurs when the indicator moves higher as the asset moves lower. A negative divergence occurs when the indicator moves lower as the asset is moving higher.
OVERBOUGHT AND OVERSOLD INDICATORS
When acting on any Stochastic Oscillators market signal, a trader should confirm the signal with another technical indicator. The Relative Strength Indicator is an excellent option for verifying the veracity of the current trend, while Bollinger Bands® provide insight into the volatility of the currency pair.
↗ When the %K line of the stochastic scale climbs to more than 80, analysts interpret an overbought condition which could lead to a sell-off forcing the price downwards.
↘ When the %K line falls below 20 on the stochastic scale, the market may be interpreted as oversold, and traders may start buying.
Stochastic RSI is an oscillator that varies between 0 and 1, and represents the level of the RSI indicator relative to its range over N periods.
Stochastic RSI is defined as follows:
StochRSI = (RSI - LowRSIn) / (HighRSIn - LowRSIn),
Where RSI is the current level or the RSI indicator, LowRSIn is the lowest level the RSI has reached over the last n periods, and HighRSIn is the highest level the RSI has reached over the last n periods.
When the Stochastic RSI is above 0.80, the target currency pair is considered to be overbought and a downward correction might be expected in the near future.
Conversely, when the Stochastic RSI is below 0.20 the target currency pair is considered to be oversold and an upward correction might be expected in the near future.
Some consider the Stochastic RSI crossing the 0.50 line as a confirmation of other signals. Crossing the 0.50 line in an upwards direction after it identified an oversold situation is considered as a buy signal. Crossing the 0.50 line in a downwards direction after it identified an overbought situation is regarded as a sell signal.
If the Stochastic RSI is increasing when it crosses the 0.20 line and the target exchange rate are still declining, it can be interpreted as a buy signal. Conversely, if the Stochastic RSI is decreasing and crosses the 0.80 line while the target exchange rate is still rising, then this is sometimes interpreted as a sell signal.
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