The stochastic indicator is a wonderful little device no forex trader wants to be without. The beauty of it is being able to see at a glance the momentum in the forex market.
Based upon an oscillator process it calculates the momentum (the pressure or weight behind the current trend). It uses the concept of while prices are rising, the closing price will tend to be higher than it would be if the market was stable. And, when prices are falling the closing price will tend to be low.
Base upon this assumption the oscillator measures when a trend is considered to have reached its limit and is about to turn.
The actual calculations are complex but fortunately you do not need to do them because most trading software will do this automatically for you. This means that you should be able to access the indicator plotted on a chart in your forex brokerage account.
The stochastic indicator will give you two lines that usually run fairly close together:
– the line called %K gives a comparison of the last closing price to previous closing prices.
– the line called %D smooths out the %K line and can be used as a signal line.
So what does the stochastic indicator actually tell you, and how can you use it to make money?
Using it is quite simple. It gives a signal that a market is overbought or oversold. In other words, it will tell you when a trend should be about to reverse, according to the basis of their calculations.
If both lines are high, this is a signal that the market is overbought. If you are trading forex on the basis of this indicator you would put in an order to sell.
Conversely if both lines are low, they are telling you that the market is oversold and you could put in an order to buy.
Keep in mind that you should not trade on the basis of one indicator alone, but always seek confirmation from at least one other.
You will normally have horizontal lines on your charts marking the high and low points for you so that you can see at a glance when to act. In many cases you can alter the position of these lines to suit your trading style. The most common settings are 70, 75 or 80 for the high line and 30, 25 or 20 for the low line.
If your settings are closer (70 and 30) you will want the stochastic lines to stay above or below your trigger lines for a longer time before you trade. If your settings are at 80 and 20, any movement above them would be a strong signal. Check this out with your own backtests to decide when you would be comfortable putting in an order.
Many currency traders also regard the relative positions of the two stochastic indicator lines as a signal for forex trading. They would buy when %K crosses %D line from below going upwards, or from above going downwards.