How to Trade with Stochastic Oscillator

Stochastic is a simple momentum oscillator developed by George C. Lane in the late 1950’s. Being a momentum oscillator, Stochastic can help determine when a currency pair is overbought or oversold. Since the oscillator is over 50 years old, it has stood the test of time, which is a large reason why many traders use it to this day.

Though there are multiple variations of Stochastic, today we’ll focus solely on Slow Stochastic.

Slow stochastic is found at the bottom of your chart and is made up of two moving averages. These moving averages are bound between 0 and 100. The blue line is the %K line and the red line is the %D line. Since %D is a moving average of %K, the red line will also lag or trail the blue line.

Traders are constantly looking for ways to catch new trends that are developing. Therefore, momentum oscillators can provide clues when the market’s momentum is slowing down, which often precedes a shift in trend. As a result, a trader using stochastic can see these shifts in trend on their chart.

Momentum shifts directions when these two Stochastic lines cross. Therefore, a trader takes a signal in the direction of the cross when the blue line crosses the red line.

As you can see from the picture above, the short term trends were detected by Stochastic. However, traders are always looking for ways to improve signals so they can be strengthened. There are two ways we can filter these trades to improve the strength of signal.

1 - Look for Crossovers at Extreme Levels

Naturally, a trader won’t want to take every signal that appears. Some signals are stronger than others. The first filter we can apply to the oscillator is taking cross overs that occur at extreme levels.

Learn Forex: Filtering Stochastic Entry Signals

Since the oscillator is bound between 0 and 100, overbought is considered above the 80 level. On the other hand, oversold is considered below the 20 level. Therefore, cross downs that occur above 80 would indicate a potential shifting trend lower from overbought levels.

Likewise, a cross up that occurs below 20 would indicate a potential shifting trend higher from oversold levels.

2 - Filter Trades on Higher Time Frame in Trend’s Direction

The second filter we can look to add is a trend filter. If we find a very strong uptrend, the Stochastic oscillator is likely to remain in overbought levels for an extended period of time giving many false sell signals.

We would not want to sell a strong uptrend since more pips are available in the direction of the trend. (see “2 Benefits of Trend Trading”)

Therefore, if we find a strong uptrend, we need to look for a dip or correction to time a buy entry. That meanswaiting for an intraday chart to correct and show oversold readings.

At that point, if Stochastic crosses up from oversold levels, then the selling pressure and momentum is likely alleviated. This provides us a signal to buy which is in alignment with the larger trend.

In the EURJPY chart above, prices were well above the 200 Day Simple Moving Average (the moving average wasn’t shown because it was well below the current prices). Therefore, if we filtered trades according to the trend on a daily chart, then only the long signals (green arrows) would have been taken.

Therefore, traders use Stochastic to time entries for trades in the direction of the larger trend.

Try it out for yourself. Enroll for a free practice account and take Stochastic signals in the direction of the larger trend.

Central Banking

Central Banking

Central Banks are institutions are utilized by nations around the world to assist in managing their commercial banking industry, interest rates and currency. The idea of a Central bank is not a new one though. The first examples of a central banking authority were seen in China with the first issuance of paper money nearly 1000 years ago. Other examples date back to the Knights Templar, looking for credit to finance their crusades. Many of the processes being tested in the past have been refined over hundreds of years of practice resulting in today’s modern banking systems.

Examples of Central Banking today include the Federal Reserve of the United States, European Central Bank (ECB), Bank of England (BOE), Bank of Canada, and the Reserve Bank of Australia. There sphere of influence of a central bank may range from a single country such as the Reserve Bank of Australia or, represent policy created for a region or group of countries such as the ECB. To show the effects of Central Banking in a modern society, we will focus on the Federal Reserve of the United States and their policy decisions.

The Fed

The origins of Central Banking developed in the United States as far back as the Revolutionary War. In 1775 the Continental Congress met with the intention of developing a national currency and a plan to finance the developing war effort. The sole value of the “Continental” relied on the future tax collection of the future independent nation. As the revolution drew on with no conclusion, overprinting and counterfeiting brought about the devaluation and ultimate demise of the Continental currency. When the constitutional convention of 1787 convened, one of the first priorities was the discussion of the current financial system. As of 1791 the First Bank of the United States was issued its original charter.

Much has changed since 1787! The Central Banking system of the United States is now known as The Federal Reserve, or simply the “Fed”. The modern Fed was created in 1913 by congress with the intent of providing the United States with a safer and consistently stable monetary system. The Federal Reserve achieves its goals by conducting monetary policy, and supervising and regulating banks.

Bank Regulations

The primary reason for the creation of the modern Federal Reserve System was to stave off banking panics in the United States. This issue came to a head in 1907 during what has been dubiously called the “Bankers Panic”. During this time, stocks on the New York Stock Exchange fell nearly 50% from their 1906 highs. The end result of this crisis is that many banks and business were forced to either close or declare bankruptcy. As people worried they funds were unsafe at local banks, they would rush to withdrawal funds creating a massive shortage of capital.

The Federal Reserve is setup to avert a crisis such as the one experienced in 1907. A system is set in place where short term needs of small local banks can be handled if a “run” on deposits occurs due to unexpected withdrawals or regional emergencies. The Federal Reserve can easily loan money to small regional banks at a nominal charge called the discount rate. Once a run has been met, banks can then return their obligation back to the Federal Reserve. This policy is one of many tools the fed utilizes assuring the solvency of financial markets and bank depositories.

What Exactly is Monetary Policy

Monetary policy is another tool directly at the Feds disposal to achieve its goals. Monetary policy describes the actions that the Fed takes to control the money supply inside of the United States. Depending on the state of the economy, the fed may select to either take an expansionary or contractionary policy, with the supply of money being influenced by two specific methods.

During times of economic slowdown, the Fed often selects to peruse an expansionary policy in the market. This process begins by expanding the monetary base and decreasing interest rates. The theory behind expansionary policy is to make money more available to banks and businesses in an attempt to increase growth and development. As a byproduct of an expansionary policy, fundamental indictors such as GDP are expected to grow and unemployment decline.

As the economy heats up, the Fed will consider taking on contractionary measures. At this point, the monetary base may begin to be restricted and interest rates can begin to increase. These actions make excess investment capital scares, and place a higher premium on lending. With less capital circulating, the economy is expected to contract and slow down. During a time of contraction, GDP is expected to decline and unemployment to contrarily increase.

Effects on Currency Rates

By controlling the money supply, and interest rates, the decisions mandated by the Federal Reserve System have a direct influence to the strength / weakness of the USD. Previously, we discussed that when an expansionary policy is put in place, the monetary base is increased and interest rates decrease. By supplying more money to the market and banks than what is demanded values increase. This over supply of funds creates a flood of cheap dollars onto the open market, effectively diluting their value. The same holds true with Interest rates in an expansionary environment. As interest rates move lower, it becomes easier to borrow funds and the value of a currency tends to decline.

The opposing scenario holds true when the Fed assumes a contractionary monetary policy. A decrease in money supplied on the open market make capital scare. Scarcity drives up value for remaining funds and increases the value of currency. Increasing interest rates also has the same affect. Higher rates make funds more expensive to borrow, the barrier for lending decreases the availability of funds. Again as capital becomes scarce, currency prices are expected to appreciate.

What this Means to Traders

Knowing which policy cycle a central bank is taking can be a fundamental asset to currency traders. One recent example of a bank taking expansionary measures is the European Central Bank. One policy the European Central bank has employed is the lowering of interest rates. From their peak levels of 4.25% in 2008, the rates have declined 3.25% to an effective rate of 1.00%. Factor this in with an expanding monetary base as new debt is extended and refinanced, the Euro has been in a state of decline versus most major currency pairs. Below we can see the Euros descent against the Australian Dollar from 2008 – present. So far this pair has produced a maximum trend of over 8000 pips. We can use this directional bias in the market to then proceed and trade the strategy of our choice.

Interest Rates

Interest Rates

If there is one overriding influencing factor in the currency market, it is interest rates. The Central Bank of a country or economic group sets the interest rate on their currency.  They adjust these rates in an effort to encourage trade and maintain control over inflation.  Lower interest rates will encourage economic expansion, as credit becomes cheaper.  Higher interest rates will retard economic expansion as the “cost of money” becomes more expensive.  Changes in interest rates can also greatly affect the value of a currency, which we shall talk of in more detail later.
Following the interest rate decisions for the Federal Reserve’s Open Market Committee (FOMC), which sets the overnight Fed Funds Rate, is extremely important when trading the U.S. Dollar. When the Fed raises interest rates, the yield offered by dollar-denominated assets are higher.  This generally attracts more traders and investors.  If interest rates are lowered, that means that the yields offered by dollar-denominated assets are less, which will give investors less of an incentive to invest in dollars.  Yet it is not just the rate itself that is important.  What is also very critical for FOMC decisions is the language in the statement that accompanies the FOMC’s decision.  Actually, oftentimes by the time of the decision announcement, the decision has already been factored into the market; only slight fluctuations are seen if the decision was the decision that was expected.  The accompanying statement, on the other hand, is analyzed word-for-word for any signs of what the Fed may do at the next meeting. Remember, the interest rate decision itself tends to be less important than the expectations for future interest rate moves.

Below is a table of the interest rates on the major currencies as of this writing in October, 2009.

Each currency carries with it an interest rate.  This is almost like a barometer of that economy’s strength or weakness.  As a nation’s economy strengthens over time, prices tend to rise as the consumers are able to spend more of their income.  The more we make, the better our vacations can be, and the greater amount of goods and services we are able to consume.  In other words, more dollars are chasing roughly the same amount of goods and this leads to higher prices for those goods.  The rise in prices is called inflation, and Central Banks watch this very closely.  If inflation is allowed to run rampant, our money will lose much of its buying power, and ordinary items such as a loaf of bread may one day rise to unbelievably high prices such as a hundred dollars per loaf.  It sounds like an unlikely far-fetched scenario but this is exactly what occurs in nations with very high inflation rates, such as Zimbabwe.  To stop this danger before it emerges the Central Bank steps in and raises interest rates in order to stem inflationary pressures before they get out of control.  Inflation is very difficult to stop once it begins, hence the Fed’s constant, almost paranoid vigilance in the fight against it.  Higher interest rates make borrowed money more expensive, which in turn dissuades consumers from buying new homes, using credit cards, and taking on any additional debts.  More expensive money also discourages corporations from expansion, as so much business is done on credit, from which interest is always charged.  Eventually, higher rates will take their toll as economies slow down, until a point where the Central Bank will once again begin to lower interest rates, this time to encourage economic growth and expansion -- and so the cycle continues.  Trying to foster growth while at the same time keeping inflation low is the delicate tight rope that the Fed walks during each FOMC meeting.  Other Central Banks also do the same at their regular meetings.

By increasing interest rates, a nation can also increase the desire of foreign investors to invest in that country.  The logic is identical to that behind any investment: The investor seeks the highest returns possible.  By increasing interest rates, the returns available to those who invest in that country increase.  Consequently, there is an increased demand for that currency as investors invest where the interest rates are higher.  Countries that offer the highest return on investment through high interest rates, economic growth, and growth in domestic financial markets tend to attract the most foreign capital.  If a country's stock market is doing well, and they offer a high interest rate, foreign investors are likely to send capital to that country.  This increases the demand for the country’s currency, and causes the currency’s value to rise.

Money will always follow yield.  Should a country increase its interest rate, we will see the general international interest in that currency increase as well.  Recently, the Reserve Bank of Australia (RBA) raised the interest rate on the Aussie Dollar 25 basis points to 3.25%.  The AUD was already strong against other currencies and this move will only serve to strengthen it further.  As a result, pairs such as the AUD/USD, AUD/JPY, GBP/AUD have reflected that strength.  Conversely, should the Central Bank of a country lower the interest rate, we will see capital flow away from that particular currency.

Some of the characteristics of Central Banks are:

• They have access to huge capital reserves.

• They have specific economic goals.

• They regulate money supply and interest rates.

• They set the overnight lending rates to change the rate of interest paid on their domestic currency.

• They buy and sell government securities to increase or reduce the supply of money.

• They sometimes buy and sell their domestic currency in the open market to influence exchange rates.

Clearly interest rates and their changes can have strong impact on the capital flow that a country experiences.

Let me give you a quick overview of the concept of Capital Flows and some of the differences between a positive and negative capital flow.

As we discussed in the last lesson, capital flows represent money sent from overseas in order to invest in a country’s markets.  They can greatly affect a nation's currency price, as a positive capital flow shows demand for investments in that nation's currency, while a negative capital flow would show weak demand compared to supply.

As you might suspect based on the significance of this topic, mere discussions by Central Banks of potential changes in interest rates are followed very closely and can themselves impact how related currency pairs move.  Clearly any announcement of an actual interest rate change are met with rapt attention on the international economic stage and can be potentially trend-changing events for currencies.

The main Central Banks involved in this process are the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, the Federal Reserve (US), Swiss National Bank, the Reserve Bank of Australia and the Reserve Bank of New Zealand.

The individual banks meet on a regular basis, generally on a 4 to 6 week cycle, depending on the bank in question.

What is Forex Trading?

                                                                                                                                          What is Forex 

The foreign exchange market is the "place" where currencies are traded. Currencies are important to most people around the world, whether they realize it or not, because currencies need to be exchanged in order to conduct foreign trade and business. If you are living in the U.S. and want to buy cheese from France, either you or the company that you buy the cheese from has to pay the French for the cheese in euros (EUR). This means that the U.S. importer would have to exchange the equivalent value of U.S. dollars (USD) into euros. The same goes for traveling. A French tourist in Egypt can't pay in euros to see the pyramids because it's not the locally accepted currency. As such, the tourist has to exchange the euros for the local currency, in this case the Egyptian pound, at the current exchange rate.

The need to exchange currencies is the primary reason why the forex market is the largest, most liquid financial market in the world. It dwarfs other markets in size, even the stock market, with an average traded value of around U.S. $2,000 billion per day. (The total volume changes all the time, but as of August 2012, the Bank for International Settlements (BIS) reported that the forex market traded in excess of U.S. $4.9 trillion per day.)

One unique aspect of this international market is that there is no central marketplace for foreign exchange. Rather, currency trading is conducted electronically over-the-counter (OTC), which means that all transactions occur via computer networks between traders around the world, rather than on one centralized exchange. The market is open 24 hours a day, five and a half days a week, and currencies are traded worldwide in the major financial centers of London, New York, Tokyo, Zurich, Frankfurt, Hong Kong, Singapore, Paris and Sydney - across almost every time zone. This means that when the trading day in the U.S. ends, the forex market begins anew in Tokyo and Hong Kong. As such, the forex market can be extremely active any time of the day, with price quotes changing constantly.

Spot Market and the Forwards and Futures Markets

There are actually three ways that institutions, corporations and individuals trade forex: the spot market, the forwards market and the futures market. The forex trading in the spot market always has been the largest market because it is the "underlying" real asset that the forwards and futures markets are based on. In the past, the futures market was the most popular venue for traders because it was available to individual investors for a longer period of time. However, with the advent of electronic trading, the spot market has witnessed a huge surge in activity and now surpasses the futures market as the preferred trading market for individual investors and speculators. When people refer to the forex market, they usually are referring to the spot market. The forwards and futures markets tend to be more popular with companies that need to hedge their foreign exchange risks out to a specific date in the future.

Who trades currencies?

Daily turnover in the world's currencies comes from two sources:

Foreign trade (5%). Companies buy and sell products in foreign countries, plus convert profits from foreign sales into domestic currency.

Speculation for profit (95%).

Most traders focus on the biggest, most liquid currency pairs. "The Majors" include US Dollar, Japanese Yen, Euro, British Pound, Swiss Franc, Canadian Dollar and Australian Dollar. In fact, more than 85% of daily forex trading happens in the major currency pairs.

Why trade Forex?

With average daily turnover of US$4 trillion, forex is the most traded financial market in the world.

A true 24-hour market from Sunday 5 PM ET to Friday 5 PM ET, forex trading begins in Sydney, and moves around the globe as the business day begins, first to Tokyo, London, and New York.

Unlike other financial markets, investors can respond immediately to currency fluctuations, whenever they occur - day or night.

How to Find a Broker for the FOREX Trading Market

It's not always easy to know what to look for in a broker in any market, much less a market as complex as the FOREX. But, if you want to trade in FOREX you need a broker. While it might be tempting to simply ask the brokers what they can do for you, you can't always depend on them to give you a straight answer. Here are a few things to consider when choosing your broker. You will want a broker that has low spreads. Since FOREX brokers don't charge a commission, this difference is how they make money. Low spreads will save you money. Along with this, you should be looking for a broker attached to a reputable institution. Unlike equity brokers, FOREX brokers are usually attached to large banks or lending institutions. The broker should also be registered with the Futures Commission Merchant (FCM) as well as regulated by the Commodity Futures Trading Commission (CFTC). Once you've narrowed your choices down to brokers that won't cost you too much, and that are reputable, consider the trading tools that they are offering you. FOREX brokers have many different trading platforms for their clients, just like brokers in other markets. These often show real-time charts, technical analysis tools, real-time news and data, and may even offer support for the various trading systems. Before you commit to any one broker, request free trials of their tools. Brokers generally provide technical as well as fundamental commentaries, economic calendars, and other research to help you make good trades. Shop around until you find a broker who will give you what you need to succeed. The next item that you will need to evaluate carefully is the number of leverage options your potential broker has. Leverage is a necessity in FOREX trading because the price deviations in the currencies are set at fractions of a cent. Leverage is expressed as a ratio between the total capital that is available to be traded and your actual capital. For example, when you have a ratio of 100:1, your broker will lend you $100 for every $1 of actual capital you have. Many brokerage firms will offer you as much as 250:1. If you have low levels of capital you will need a brokerage with high levels of leverage to make reasonable profits. If capital is not a problem, any broker that has a wide variety of leverage options would be a good choice for you. A variety of options will let you vary the amount of risk you choose to take. For example, less leverage (and therefore less risk) may be preferable if you are dealing with highly volatile (exotic) currency pairs. Along with different levels of leverage, look for brokers that offer different types of accounts. Many brokers will offer you two or more types. The smallest account is known as a mini account and it requires you to trade with a minimum of around $300. The mini account also generally offers a high amount of leverage. The standard account allows you to trade at a variety of different leverages, but it requires minimum initial capital of $2,000. And finally, there are premium accounts, which often require significant amounts of capital. They also generally have different levels of leverage available to the traders who use them, and often offer additional tools and services. You will need to make sure that the broker you choose has the right leverage, tools, and services for the amount of capital that you are able to work with.

Used Margin vs. Usable Margin in FOREX Trading

The subject of FOREX margin has been the source of a lot of confusion over the years. Many traders that regularly trade FOREX have no idea how margin works in their accounts. They know that they could possibly get a margin call, but they do not fully understand how they work. The terms "used margin" and "usable margin" are both important but many traders do not understand the difference. Here are the basics of used margin and usable margin in FOREX trading.

Used Margin

Depending on what type of FOREX account you have, you could have varying levels of margin requirements. Some popular levels of leverage are 100:1 and 200:1. If you open a trade for one standard lot, your used margin will be $100. This is the amount of margin that you have used out of your total equity.

Usable Margin

The usable margin is the amount of money that you have left to use. The usable margin is always equal to the equity in your account minus the used margin. Some people think that it is calculated off of the account balance, but this is not true. It is always calculated off of the equity.

In the earlier example, if you had a $10,000 account and you opened a trade for one lot, your used margin is $100. Your usable margin is $9900.

What is a Pip?

“PIP” stands for Point In Percentage. More simply though, a pip is what we in the FX would consider a “point” for calculating profits and losses.

When trading a mini lot (10k units of currency), each pip is worth roughly one unit of the currency in which your account is denominated. If your account is denominated in USD, for example, each pip (depending on the currency pair) is worth about $1. In a micro lot, or 1k trade, each pip is worth roughly 1/10th the amount it would be worth in a mini lot -- so about $0.10.

In all pairs involving the Japanese Yen (JPY), a pip is the 1/100th place -- 2 places to the right of the decimal. In all other currency pairs, a pip is the 1/10,000 the place -- 4 places to the right of the decimal.

You’ll see that in the Trading Station the digits for pips are in a larger font. This makes them easier to see.

At FXCM, we provide additional transparency through the electronic platform and quote each currency pair with precision to 1/10th of a pip. This fraction of a pip allows price providers to bring spreads down even further as they are not restricted to quoting in full pip increments. This is beneficial to you, the trader, because the spread is a component of your transaction cost.

You’ll notice that earlier in this post, we mentioned that the value of a pip for a 10,000 unit trade is roughly equal to 1 unit of your denominated currency (or $1 if you have a USD account).

Now, let’s identify what the actual value per pip is. There are two simple methods to determine this.

First, in the dealing rates of the FXCM Trading Station II platform, you will find the value per pip of the smallest trade size.

In the account above, the minimum trade size is 1k. Therefore, the pip value listed in the advanced dealing rates window is based on a 1k trade size. For the EURUSD, that means every pip is $0.10. So the spread in the image above was 2.6 pips x 0.10 = $0.26 was the transaction cost to get into that trade.

How do I know that 1k is the smallest trade size for the account? Simple!

When you open a trade, a pop up box appears. In the Amount(K) field, open up the drop down box and what is the smallest figure you see? In the example above, 1 appears meaning it is a 1k minimum trade size for the USD/JPY.

For the second method of determining the value per pip, open the “Market Order” pop up box by left clicking on the dealing rate like you are going to place a trade.

You’ll notice, that when you change the Amount(K) field, the “Per Pip” value changes accordingly. Therefore, just before you get ready to enter the trade, simply double check that the “per pip” field is what you are comfortable with.

If you are not sure what cost per pip you are interested in, no worries. Later on, we will show you how to use support and resistance to help you determine trade size. If you are already familiar with support and resistance, use this three step guide to determine trade size.

For those who wish to determine the calculation by hand, follow this method below (if you are not interested in the mathematics involved, then proceed to the next article).

First you start with the size of your trade. Micro lots are 1k, so if you want the value of a pip for a micro lot you start with 1,000. If you want the value of a pip for a mini lot, you start with 10,000. You then multiply your trade size by one pip for the pair that you are trading.

In this example we are going to calculate the value of a pip for one 10k lot of EUR/USD.

So since I am using 10k mini-lot, I’m starting with 10,000. I multiply 10,000 by .0001 since 1/10,000th is a pip for all pairs (except JPY pairs).

That gets me a value of 1. That will be valued in the “counter currency” (second currency) of the pair that I am trading. In this example, I am trading EUR/USD, so USD is the counter currency of the pair. One pip is worth 1 USD dollar for one 10k lot of EUR/USD.

If my FXCM account is based in US Dollars, then I will see $1 of profit or loss on my account for every 1 pip move that the EUR/USD makes in the market.

Now, if my FXCM account is based in Euros (EUR), I would have to convert that $1 USD into Euros. To do so, I just divide by the current EUR/USD exchange rate which at the time of writing is 1.3797. I’m dividing here because a Euro is worth more than a USD, so I know my answer should be less than 1. 1 divided by 1.3797 is 0.7248 Euros. So now I know that if I have a Euro based account, and profit or lose one pip on 1 10k lot of EUR/USD, I will earn or lose 0.7248 Euros.

Let’s do another example of GBP/JPY.

Again we’ll go with a one 10k lot trade.

This time a pip is .01 because it is a JPY pair.

10,000 times .01 is 100. Again, that “100” is in terms of the counter currency, so it is 100 Japanese Yen (JPY).

Now we need to convert that 100 Yen to the denomination of your account. If you have a USD based account, then you take the 100 Yen and divide it by the USD/JPY spot rate, which at the time of this writing was 105.11. That gets you an answer of $0.95 per pip.