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  1. 10 Tips of Successful Commodity Trading
  2. A Profitable Trading System Built On the Stochastic
  3. Guide to Using VPS for Expert Advisors (EA)

A Profitable Trading System Built On the Stochastic

The Stochastic Oscillator is a creation of George C. Lane and consequently had its introduction to the trading community in the late 1950s. The stochastic oscillator is notably one of the first technical indicators which analysts used to get insight into the possible future direction of market prices.

The Stochastic Oscillator works on the assumption that during a market uptrend, prices will remain equal to or possibly above the closing price of the last (previous) period. In this same line of reasoning, when a possible market downtrend occurs, prices could possibly remain equal to, or even below the closing price of the previous period.

The stochastic oscillator makes use of a scale in trying to estimate the extent of price changes from one closing period to the next; this way the Stochastic Oscillator tries to make the prediction of the chances of the current trend continuing or even changing. When using the stochastic, you will have to watch out for signals which were generated by means of the stochastic lines.

Before we go properly into how we could use the stochastic oscillator in timing our trades; as to when to buy or sell, it is would be beneficial if we add here that the Stochastic Oscillator itself is made up of two lines. You have the Full Stochastic when both lines are included on a price chart. These two lines we are talking about here are:

%K line and the %D line. The %k lines help the trader to keep track of current market prices or say exchange rates for a given currency pair. The other line which is known as the %D  plays the role of "smoothening" the %K line by means of calculating and plotting the current prices as a moving average - you can also see this as the signal line.

In the picture above, the green line is the %K line, while the red line is %D Stochastic.

Note that in most conditions the %k line N is set to 14 periods as this for sure takes an adequate amount of data to calculate with, giving us more accurate signals.

You could choose to alter the number of periods but bear in mind that this could also change the effectiveness of the results you could get. The %D Stochastic makes use of the last three valuations of %K so as to create a three-period moving average of the %K Stochastic. What you get at the end is a "smoothened" version of %K. For the fact that the %D is a moving average of %K, some traders prefer to call it the "Stochastic Slow". This is because it reacts more slowly to market price changes as compared to the %K stochastic which is noticeably faster. Also, you could as well as call the %K the "Stochastic Fast".

Now that is all for the introduction. Let us get proper into how you can make use of the Stochastic Oscillator to generate signals of when to buy as well as signals for when to sell.

Basically, The Stochastic Oscillator produces three types of signals. They are:

  • Crossovers

  • Overbought / Oversold conditions and

  • Divergence (the trend's strength)

 Let’s start here with the crossover signals generated by the Stochastic Oscillator.

Crossovers

When it comes to the Stochastic Oscillator, a crossover happens when the %K line (which we know as the fast stochastic) intersects the %D line (which is also known as the slow stochastic).

For the fact that the %K line has a quicker reaction to market changes, it will now oscillate at a faster rate than the %D line. When certain conditions show up, it can catch up with the %D line, and then it will cross over the %D line. In such situation where the %K Stochastic crosses over and then goes above the %D Stochastic, what this means is that the market rate is gaining at a faster rate than the average shown by the %D Stochastic. As such this is an increase in price strength and such an increase would be seen as a buy signal. So does one get a sell signal?

You could have a sell signal when the %K Stochastic crosses under the %D Stochastic. This happens when the faster-moving %K line is now falling at a rate faster than the overall downward trend. So simply when the %k Stochastic crosses under the %D stochastic, it is telling you it could be time to sell as market prices could possibly start falling any time soon.

The picture shows the points of crossovers well mapped out in circles in the EURUSD M5 price chart. The blue line there, is the %K stochastic, while the gray one is the %D Stochastic. The reading of 14, 3, 3 tells you that the %K Stochastic has the period of 14 and the % D has a period of 3 with a slowing of 3 applied to low/high price fields. So when the %K stochastic crosses the %D stochastic upwards, you have your buy signal and if it goes otherwise with the %K crossing

Divergence

When we say divergence, we simply mean the difference – or better said the gap – between the %D and %K Stochastic lines.

Owing to the fact that the %K line moves at a faster rate than the %D line, the divergence (the gap) between the two stochastic will now increase as a trend gets more momentum. However, the lines will get closer together as momentum reduces which most times happen before a rate reversal.

So, as the divergence is increasing, you already know that a reversal is likely and the trend would be changing soon, hence it could be time to either buy when it is a change for an increase in exchange rates or sell when it is a change for a decrease in market prices.


The pictorial representation above does well to make the points clearer. The circled area shows an increasing divergence followed by a reduction.

Overbought And Oversold Conditions.

This is where we really want to dwell on. Overbought and Oversold conditions are typically one of the most traded signals generated by the Stochastic Oscillator.  If you look at your Stochastic oscillator on your price chart below you will see the dotted 80-line and then the dotted 20-line.



 Those regions of the Stochastic scale marked by those lines will tell us when we have an overbought condition or an oversold condition.

So if the momentum %K line goes up, climbing into the 80 and above region of the Stochastic scale, you have your overbought condition. An overbought condition suggests that prices may soon crash so it is best to sell then; hence an overbought condition generates a sell signal.


Now when the %K line falls below 20 on the Stochastic scale, you may take this as an oversold condition. The interpretation here is that traders may soon begin buying as a result prices could rise up anytime soon, hence, it is time to buy. So an oversold condition when using the Stochastic oscillator generates a buy signal.


Example of Overbought and Oversold conditions

The truth here is we can't be extremely confident of the accuracy of the signal generated by the Stochastic Oscillators, so it is best you always confirm the signal by addicting another technical indicator to filter the signal from the stochastic oscillator.

What some traders basically use is the Relative Strength Indicator which is a good alternative when it comes to verifying the accuracy of the current trend. Some traders would make use of Bollinger Bands to get an idea of the volatility of the currency pair in question.

To make the entry points signal generated from the Stochastic more accurate, we make use of a trading system that is made up of the Stochastic Oscillator and Magic Oscillator by Bill Williams. To install the Magic Oscillator on your MT4, we will now press the button Indicators at a toolbar, from there we will proceed to select from the menu that shows Bill Williams - Awesome Oscillator.

You can change the settings.

The magic oscillator will give you a signal on the buy or sell, and it is called the "Saucer"; Green bar after two red bar or red bar after two green. This will be a turn signal.

To realize a complete strategy, we would rather encourage you to enter tactics of an output from the transaction. So to control our losses as a measure of risk management, we place the stop loss on the level of the last fractal. It is a turn signal.



Also, we could now close the trade if we possibly get a signal, opposite in the direction, for an input. And this brings us to the end of this trading system.