I use the stochastic all the time and think there is no better indicator for timing your trading signals – its simply the ultimate momentum indicator and every forex trader should use it – lets look at this fantastic indicator in greater depth….
The stochastic indicator is:
A momentum indicator which warns of strength or weakness in advance, making it leading indicator to confirm trading signals in conjunction with support and resistance.
The Technical Bit
The stochastic is plotted as two lines %K and %D.
The %K line is the more sensitive line
The %D line is a moving average of %K.
The plotting of the stochastic is a bit similar to a moving average. Substitute the %K for the fast moving average and %D for the slower average.
The lines are plotted 1 – 100.
Here are 3 ways you can use the stochastic indicator to great affect, with crossovers from over bought – oversold being my personal favorite.
1. As a Overbought / Oversold Indicator
A common use of the stochastic is to use it as an overbought / oversold indicator. When stochastic moves below the 20% and above 80% trigger lines are crossed the Buy when the stochastic goes below 20% and then rises above that level and sell when the stochastic rises above 80% and then goes below.
2. Trading Crossovers
the crossover is my favorite way of using the stochastic from over bought above 80% or oversold below 20% Many traders simply buy when the %K line rises above the %D line and then sell when the %K line falls below the %D line.
This can work but you tend to get a lot of whips in price. I personally prefer to do crossovers from very overbought and oversold levels. In currencies you often get above 90 and below 10 and a recent currency signal I had was from 96!
When these levels are reached and you have cross the upside from oversold or down turn from overbought are great signals.
I know traders who simply use support and resistance and crossovers from extremes and make a lot of money with the stochastic and support and resistance lines.
Sure it’s simple but it’s very effective now the final use.
3. Trading Stochastic Divergences
Divergences between the stochastic and price can be used as a leading indicator for executing trading signals.
For example, if prices are making new lows and the stochastic moves higher or crosses to the upside you have a warning that prices may re bound as price move up. The opposite is of course true in a bear market.
Of course no indicator works all the time by itself – but in terms of a momentum and timing indicator for your trades, it’s a fantastic indicator if used correctly.
As stated my preference is not just to use crossovers but crossovers from price chart extremes and this with trend lines and a little practice works.
I also like to use filters in line with the stochastic and use the Relative Strength Index (RSI) and Average Directional Movement (ADX). There great as momentum indicators and work well with the stochastic. Get the book they come from – New Concepts in Technical Trading – By Wells Wilder it’s a great book and outlines them in more detail.
I have used the stochastic for 25 years and use it for swing trading and trend following and never execute a trade without checking it.
It’s a very visual indicator and you can learn to use it in 30 minutes. If you don’t know or use the stochastic, its time to make it part of your essential forex education.