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Stochastic is an oscillator
that works well in range-bound markets. Stochastic is an oscillator — meaning it
offers a measurement of the deviance of currency pair’s rate (price) from its
normal levels. Like all oscillators, stochastic offers indications of when a
currency pair is overbought/oversold. Accordingly, it works well in markets that
are not trending, but rather just fluctuating back and forth between an upper
level (resistance) and a lower level (support). Parameters. Stochastic
typically has three parameters that users must specific: %K, %D, and number of
periods. Here is one commonly used setting for those parameters: 5for%K
5for%D, 3 for number of periods %K is the fast moving line; it measures the
relative strength of the asset, like RSI. %D is a moving average of %K, and
hence is a much slower line. Different Inputs. The fast stochastic only requires
two inputs, which are normally 5 and 5. The slow stochastic requires a third
input, which is the number of periods used in taking a moving average of the
fast %D line. Unlike MACD (which commonly uses 12, 26, and 9) or RSI (which uses
14), Slow stochastic has a number of popular settings that can be used. 5, 3,
and 8 is one commonly used setting. 15, 3, 3 is used by conservative traders who
are interested in receiving less signals, while 8, 5, 5 and 5, 5, 3 are
more aggressive settings for traders who are looking for fast signals. The
tradeoff between accuracy and speed is something every trader must consider when
choosing the inputs they will use in stochastic. Stochastic can be used to
determine overbought/oversold levels, like RSI can be used in a crossover
fashion like moving averages. Its also used to spot divergences, which indicate
potential weaknesses in trends. Crossover. When %K crosses %D (When fast
crosses slow), it can be interpreted as a trade opportunity. Traders can enter
positions following the direction of %K. Overbought/Oversold. Look
for both %K and %D to be above/below the 20/80 levels. If they are both above
80, it may be a good opportunity to sell, as the asset is overbought and
expected to return back to a normal level. Alternatively, if it is below 20, the
asset is oversold — and hence it may be a prime buying opportunity, as a
range-bound market would imply that the currency pair will head back to a
more “normal” asset price. Slow versus Fast Stochastic. There are two types
of stochastic, slow and fast. Both display the same two lines, and both can be
interpreted in the same manner for crossovers, overbought/oversold conditions,
and divergence. The difference is that the %D line of the slow stochastic is
smoothed out by taking a moving average of the %D line of the fast stochastic.
This makes the slow stochastic more accurate in the trade signals it provides
but somewhat slower to react to the changing market price. Stochastic can also
be used to determine when NOT to enter a position. For instance, if a trend
looks strong, traders can look to stochastic to see if there is any divergence
between the movement of the asset and the stochastic lines. If, for example, a
currency pair is headed upwards sharply and is making new highs, but the
stochastic is not making new highs or even heading downwards, then this suggests
that the trend is weak, and the prices may come back down. Conservative traders
can use look for divergence as a caution not to enter a trade based on momentum,
while more aggressive traders can use divergence as a signal to enter a
position before the trend actually starts. Bollinger Bands are excellent
range-bound indicator that measures standard deviation from the moving average.
Developed by John Bollinger, Bollinger Bands consist of three lines. A
moving average (Often omitted in most charting packages), A upper band two
standard deviations above the moving average and lower band two standard
deviations below the moving average.
Bollinger bands are an
excellent range-bound indicator — meaning they work best when the market is not
strongly trending, but rather fluctuating between a high barrier (resistance)
and a lower barrier (support). Bollinger bands operate under the logic that a
currency pair’s price is most likely to gravitate towards its average, and hence
when it strays too far — such as two standard deviations away — it is due to
retrace back to its moving average. Parameters: Standard deviation of 2;
moving average of 20 (usually omitted). In range-bound markets, trading with
Bollinger Bands is fairly simple: it essentially involves selling at the top
band and buying at the bottom one. Note how the bands are nearly horizontal when
the market is in an established range. This is when reversals at the band are
more effective. When the Bollinger bands contract (meaning grow narrower), this
suggests that volatility is contracting, and that the pair is trading in a
tighter range. Typically, volatility right before the market might breakout.
Accordingly, contracting volatility — symbolized by tight Bollinger Bands —
should be a sign to traders that the market may be ready to make a big break.
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High Probability Trading Setups
By
Kathy Lien And Boris Schlossberg -
On Sale - |
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Kathy Lien is
the Chief Currency Strategist at Forex Capital Markets LLC (FXCM). |
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Boris Schlossberg
serves as the Senior Currency Strategist at FXCM in New York where he
shares editorial duties with Kathy Lien. |
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Learn From The Best! Download
This EBook Now. You wont be disappointed we recommended getting
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