Trading the Forex Using Stochastics

Today's post is on one of the most commonly used indicators available. It's called the stochastic Oscillator. That's actually just forex jargon for saying that a certain pair is either overbought or over sold.

Remember, all currencies are bought and sold in pairs. The stochastic measurement is based on the first currency listed in the pairing. So that if the indicator is reading over bought, and you are looking at the EUR/USD, it is the euro which is overbought and the US dollar which has been over sold.

The theory behind stochastic oscillation is that a currency pair is a lot like a rubber band. You can only push it so far in one direction before it snaps back. If the euro is overbought, that means it will reach an extreme, and then reverse, moving in favor of the dollar.

A stochastic indicator is read as following. Usually the indicator has two lines, a red and a blue. The red one is referred to as the "fast" line, the blue one as the "slow". In the course of an uptrend, they will both be rising, and the red will be above the blue. They are plotted on a scale of 0-100. Anything over 80 is considered to be over bought. Anything below 20 is considered to be oversold. An overbought currency is thought to be ready for a pullback. An oversold currency, ready for a retracement upward.

The pair of lines give a trading signal when the red crosses the blue. So if the pair has been in an uptrend, and they pass the 80 mark, you would look for them to curve back down, what I commonly refer to as "rolling over", when the red crosses back down below the blue, (the fast line crosses back down below the slow line) and they fall back under 80, you have a change, or a reversal or a pullback. As a rule, you could look for the two to continue falling until they pass below the 20 mark. You could use that as an exit.

HOWEVER, please be aware, that stochastic can remain over bought for an extended period of time. They can also remain oversold for an extended period of time. So it is possible to see an overbought currency pair go on to rise another 100 pips. So the next question is this. Do you get out if the rise continues...or do you stay in "knowing" that it has to turn around sometime?

Here are 2 answers, based on 2 different strategies. Because there is no one perfect way to trade. You can make money in the forex a lot of different ways. you just have to plan your strategy before you get in, and stick with it rain or shine (assuming, of course, that your strategy is a sound one).

So if you have entered the trade based on the parameters that I just gave you, and are now short the eur/usd, if you do not like to carry losses or draw downs, you will want to formulate an exit even before you enter. You do this by looking at the last swing high in the eur/usd. Now that may be a few number of pips away, or it could be many. Usually it will depend on the time frame of the chart you are looking at. If you are using an hourly chart, it will be further than on a 5 minute chart. But remember, the longer the time frame on the chart, the better and more reliable the signals are. So if you think about that, here's what it means. If you trade on shorter term time frames, you WILL have more losing trades, than on the longer term charts. But they will be smaller losses. If you use longer term charts, your losses will be larger, but there will be fewer of them. Also, it is important to remember that your profits are usually smaller on shorter time frame charts. So it is important to know what kind of trader you are. What amount of risk you can tolerate. And how long you are willing to hold your draw downs...both in the amount of time, and also in the number of pips. I have thrown a lot of variables at you, and we're not finished yet. So if you don't like holding draw downs, you want to form your exit strategy by means a stop loss.

However, I don't mind draw downs my self, so I will let the trade work against me sometimes several hundred pips. The big difference is, I do know my ultimate stop loss, and I will keep adding to my losing position at important resistance points as the pair continue higher. Thus, even if I have gotten in early by way of a false signal, I can still increase my position, and when it does hit its final reversal point, I may have 3 or 4 positions when it does reverse. So even if it doesn't get to my original entry point, I'll still have a winning trade, because my other positions have paid off handsomely. Again, the one caveat is this, you have to be willing to accept draw downs. Often the trade will turn quickly, and moves rapidly into a profit. But then you're out fairly quick, and you haven't necessarily spent a long time looking at a trade in the black. but you still get the win. If these approaches make sense to you, then head on over to www.thefxtradingmsters.com.
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Drop me a comment or question about any of this if it's unclear.

Until next time...Happy Trading!

Bill