Stochastic Strategy Forex Trading

The stochastic strategy on its own relies on a single stochastic oscillator, which is only partly useful. In this approach I combine two of them, one slow and one fast, and watch for a very specific thing to happen on the chart. Follow along below.

Stochastic Strategy and Settings

This double stochastic forex trading strategy combines a slow stochastic oscillator and a fast one, then looks for moments when the two signals point in opposite directions. The extreme boundaries are defined as the 80% and 20% levels (the illustrations below give the clearest picture of what is meant).

The only other indicator you might want to keep in mind for this strategy is the 20 EMA, and even that is not essential. The stochastic settings are as follows:

Slow stochastic oscillator:

• %K: 21
• Slowing: 10
• %D: 4

Fast stochastic oscillator:

• %K: 5
• Slowing: 2
• %D: 2

For MetaTrader, these settings are shown in the charts below (the colour choices are up to you):

Slow stochastic settings in MetaTrader:

Fast stochastic settings in MetaTrader:

Note: in the examples below I combined both stochastics in a single window at the bottom of the MetaTrader chart. You may find this more convenient, and it is easily done. First place one stochastic on the chart, then drag the next stochastic from the navigator window in MetaTrader and drop it on top of the first one. The dialog box for entering the settings will appear automatically.

Stochastic Strategy and Basic Rules

• Wait until price is trending strongly.
• Watch for the stochastics at the opposite extreme.
• Then, to confirm, look for a suitable candlestick pattern that signals a reversal after a short pullback to the 20 EMA.

Note that you can also use the middle band of the Bollinger Bands as an alternative to the 20 EMA.

To go straight to some trade examples, take a look at the next chart. These examples are taken from one-hour charts, since that is a good time frame for trading this particular pattern.

The circles mark potential entry points for a short in a downtrend. Notice how the slow stochastic (the yellow indicator band) is deep in oversold territory while the fast stochastic (the blue line) has just stalled after being overbought.

The third example is a slightly borderline case where the slow stochastic has started to rise out of the oversold zone. On the other hand, price made a double top and fell convincingly, so this would be a judgement call for you to trade.

Above: a classic short entry in a confirmed downtrend. Notice how the flat slow stochastic signalled a sell in oversold territory, together with a fast stochastic turning down near the overbought zone. The bearish candle is not a classic pattern, but it is confirmed by the candles that follow.

Above: the first circle marks the classic close entry point where price has now dropped below the old support level and is pulling back, a winning trade.

The second circle marks a textbook evening star pattern at the 20 EMA, but taking this trade would most likely lead to a loss or a break-even result at best, just to show that the strategy is not always perfect. Of course, all of these trades are drawn from history and we have no idea what was happening in the market at the time, which may or may not affect sentiment.

I know many traders who bend the rules a little when using this system and still do fine with it. It is an easy system to use and does not have to be applied in a rigid, mechanical way. You should always use it alongside other signals, as shown above, and always keep in mind the time of day, the session, the liquidity and so on that prevail at the time of trading.

Stochastic Strategy and Divergences

In the example above nothing is perfect. At first the slow stochastic is not in the overbought zone, and in the second case the fast stochastic is not oversold. Even so, both represent a convincing rejection at the 20 EMA after price closed convincingly above the old support level marked by the white line.

Stochastic Strategy and Confirmation Signals

With the stochastic oscillator strategy you may need to exercise your own judgement, and as always, remember to trade alongside a set of other events and signals where they are available. These are:

• Support and resistance levels
• Pivots
• Round numbers
• Fibonacci levels
• Candlestick patterns
• Trend

Of course, every strategy comes with many caveats, but after practising on a demo account you can develop the strategy and get comfortable with it.

So the fast stochastic strategy uses a technical momentum indicator that aims to measure the direction of prices and identify trend reversals. The indicator was developed by securities trader and technical analyst George Lane.

The indicator is driven by two parameters: the look-back period and the momentum factor. The look-back period is the period over which the oscillator is calculated, and the momentum factor is the number of periods over which the oscillator’s moving average is calculated. It is called an oscillator because the indicator’s value swings between 0 and 100.

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