Created by George Lane in the 1950s, the stochastic indicator is used by traders all over the world to identify oversold and overbought conditions on forex charts. Once you understand how to use it, the stochastic indicator can be an invaluable tool to help predict momentum changes in currency movements.
In this post we’ll help you understand how the stochastic indicator works, and how to get the most from it when you trade.
The stochastic indicator is fundamentally made up of two moving averages. These are usually depicted by a red line and a blue line. The blue line is known as the %K line, while the red line is known as the %D line. The %D line is a moving average of the %K line and as such usually trails the blue (%K) line.
A buy signal is typically generated whenever the blue line crosses over and moves above the red line. A sell signal is usually generated when the blue line crosses below and moves under the red line.
Given that the stochastic indicator is an oscillator, it is calibrated from 0-100. The indicator is said to be in oversold conditions when it crosses below the 20 level, and is regarded to be in overbought conditions whenever it crosses above the 80 level. Therefore, most traders would look for trading signals that occur at oversold and overbought levels.
When a currency pair is in a strong upward or downward trend, the stochastic indicator is likely to remain in oversold or overbought conditions for a long time. By using a trend filter you can filter out the false sell signals in a strong uptrend and the false buy signals in a strong downtrend.
If a currency pair is in a strong uptrend it is not advisable to buy based on the overbought signals. However, you could buy the pair whenever a dip or correction appears on the chart. The dip or correction should lead to the stochastic indicator generating a buy signal due to the presence of temporary oversold conditions, which is the best way to apply the trend filter.
The same principle applies to charts where the currency pair is in a strong downtrend, where you should ignore the oversold signals while focusing on the overbought signals. The overbought signals can provide excellent opportunities to sell the currency pair as the price will typically head lower once the overbought pressure is exhausted.
Traders should use the stochastic indicator to identify trades that align with the overall direction of the main trend. This means analyzing the longer-term charts in order to determine the prevailing trend. Doing this will ensure that you only open trades when the trade signals align with the dominant trend.
Although the fundamental rules used for both fast and slow stochastics are the same, the two types of stochastics usually generate trading signals quite differently. The fast stochastic is more sensitive to price changes and typically generates more trading signals as compared to the slow stochastic.
The fast stochastic is generally used by day traders with a focus on scalping. The slow stochastic on the other hand is more applicable to swing traders as it generates fewer, more accurate trading signals. Most traders are best served using the slow stochastic indicator as it is more readable and does not constantly react to changes in prices like the fast stochastic indicator.
Remember that you cannot use oscillatory indicators such as the stochastics to predict future trends, They can however be extremely useful in measuring the momentum based on changes in price. You should always identify the prevailing trend on the daily charts after which you can use the slow stochastic indicator to identify potential entry positions based on overbought and oversold signals that align with the prevailing trend.
In summary, the stochastic indicator is a widely used momentum indicator that is effective in identifying oversold and overbought conditions on forex charts. You should not use it as the only tool in your trading arsenal, but it should be combined with other indicators such as moving averages when creating a trading plan. Remember to always pay attention to the dominant trend when trading with signals generated by the stochastic indicator in order to eliminate false signals.
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