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Abstract: Why are stochastics and moving averages so popular amongst traders? What is their magic?

一.Introduction to Moving Averages:

What is a Moving Average？

In technical analysis, the moving average is an indicator used to represent the average closing price of the market over a specified time. Traders often make use of moving averages as it can be a good indication of current market momentum.

The two most commonly used moving averages are the straightforward moving average (SMA) and the exponential moving average (EMA). The difference between these moving averages is that the straightforward moving average does not give any weighting to the averages in the data set whereas the exponential moving average will give more weighting to current prices.

How do you calculate the moving average？

As explained above, the most common moving averages are the straightforward moving average (SMA) and the exponential moving average (EMA). Almost all charting packages will have a moving average as a technical indicator.

The straightforward moving average is simply the average of all the data points in the series divided by the number of points.

The challenge of the SMA is that all the data points will have equal weighting which may distort the true reflection of the current markets trend.

The EMA was developed to correct this problem as it will give more weight to the most recent prices. This makes the EMA more sensitive to the current trends in the market and is useful when determining trend direction.

What is the purpose of moving averages？

The main purpose of the moving average is to eliminate short-term fluctuations in the market. Because moving averages represent an average closing price over a selected period of time, the moving average allows traders to identify the overall trend of the market positively.

Another benefit of the moving average is that it is a customizable indicator which means that the trader can select the time frame that suits their trading objectives. Moving averages are often used for market entries as well as determining possible support and resistance levels. The moving average often acts as a resistance level when the price is trading below the MA and it acts as a support level when the price is trading above the MA.

How do you interpret moving averages？

There are 3 ways in which traders use the moving average:

To determine the direction of the trend

To determine support and resistance levels

Using multiple moving averages for long- and short-term market trends

1.To determine the direction of the trend:

When prices are trending higher, the moving average will adjust by also moving higher to reflect the increasing prices. This could be interpreted as a bullish signal, where traders may prefer buying opportunities.

The opposite would be true if the price was consistently trading below the moving average indicator, where traders would then prefer selling opportunities due to the market signaling a downward trend.

2.The moving average for support and resistance levels:

The moving average can be used to determine support and resistance levels once a trader has placed a trade.

If the trader sees the moving average trending higher, they may enter the market on a retest of the moving average. Likewise, if the trader is already long in an uptrend market, the moving average can be used as a stop-loss level. The opposite is true for downtrends.

The charts below are examples of how the moving average can be used as both a support and a resistance level.

3.having use of multiple moving averages

It is common for traders to make use of multiple moving average indicators on a single chart, as depicted in the chart below. This allows traders to simultaneously assess the short and long-term trends in the market. As price crosses above or below these plotted levels on the graph, it can be interpreted as either a strength or weakness for a specific currency pair. This method of using more than one indicator can be extremely useful in trending markets and is similar to using the MACD oscillator.

When using multiple moving averages, many traders will look to see when the lines will cross. This phenomenon is referred to as ‘The Golden Cross’ when a bullish pattern is formed and ‘The Death Cross’ when the pattern is bearish.

A Golden cross is identified when the short-term moving average (such as the 50-day moving average) crosses above the long-term moving average (such as the 200-day moving average), while the Death cross represents the short-term moving average crossing below the long-term moving average. Traders that are long, should view the Death Cross as a time to consider closing trade, while those in short trades should view the Golden Cross as a signal to close out the trade.

In summary, the Moving Average is a common indicator used by traders to determine trends in the market. Many traders use more than one Moving Average at a time as this gives a more holistic view of the market. Moving averages are often used to determine market entries as well as support and resistance levels.

二：The stochastic oscillator is a useful indicator when it comes to assessing momentum or trend strength. The stochastic oscillator, and oscillators in general, are presented in an easy-to-understand manner with clear buy and sell signals. However, an overreliance on these signals, without a deeper understanding of stochastic oscillators, is likely to end in frustration.

To avoid such frustration, new traders ought to have a solid understanding of the underlying mechanics of the stochastic oscillator viewed concerning present market conditions.

What is a Stochastic Oscillator？

A stochastic oscillator is a momentum indicator that calculates whether the price of a security is overbought or oversold when compared to price movement over a specified period. The oscillator essentially weighs up the most recent price level as a percentage of the range (highest high – lowest low) over a defined period of time.

How does a Stochastic Oscillator Work？

The stochastic oscillator presents two moving lines that ‘oscillate’ between two horizontal lines. The solid black line in the image below is called the %K and is determined by a specific formula (explained later in the article), while the red dotted line is a 3-period moving average of the %K line.

Price is shown to be ‘overbought’ when the two moving lines break above the upper horizontal line and ‘oversold’ once they break below the lower horizontal line.

The overbought line represents price levels that fit into the top 80% of the recent price range (high – low) over a defined period – with the default period often being ‘14’. Likewise, the oversold line represents price levels that fit into the bottom 20% of the recent price range.

**Timing entries**

Furthermore, the stochastic indicator provides great insight when timing entries. When both lines are above the ‘overbought’ line (80) and the %K line crosses below the dotted %D line, this is viewed as a possible entry signal to go short and visa versa when the %K line crosses above the %D line when both lines are below the oversold line (20).

Additionally, traders should not blindly trade based on overbought/oversold conditions alone. Traders need to understand the direction of the overall trend and filter trades accordingly. For example, when looking at the USD/SGD chart below, since the overall trend is down, traders should only look for short entry signals at overbought levels. Only when the trend reverses or a trading range is well-established, should traders look for long entries in oversold conditions.

Pros and Cons of Stochastic Oscillators

Traders ought to understand where the stochastic oscillator excels and where its short-comings lie, in order to get the most out of the indicator.

Pros | Cons |

Clear entry/exit signals | Can produce false signals when used incorrectly |

Signals appear frequently (depending on the selected time setting) | If trading against the trend, prices can remain overbought/oversold for long periods |

Available on most charting packages | |

Conceptually easy to understand |

The stochastic indicator is a great tool for identifying overbought and oversold conditions over a specific period. The stochastic oscillator is preferred by many traders when the price is trading in a range because the price itself is ‘oscillating’, leading to more reliable signals from the stochastic indicator. However, traders need to avoid blindly shorting at overbought levels in upward-trending markets; and going long in down-trending markets purely based on oversold conditions shown by the indicator.

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Another oscillator indicator that shows overbought and oversold regions is the Relative Strength Index (RSI). However, the RSI is very different from the stochastic indicator which is why traders need to understand the formula and what the indicator communicates about price.

Commodity Channel Index (CCI), although its name refers to commodities, is an indicator that can be used in forex trading too. It tends to oscillate between a reading of +100 and -100, but unlike the stochastic indicator, it uses statistical variation from the mean to produce signals.

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