When it comes to technical analysis, traders can use many different indicators to try and predict future price movements. One of these indicators is the stochastic indicator. In this article, we will look at what the stochastic indicator is and how you can use it effectively in your forex trading.
What is a stochastic indicator?
The stochastic indicator is a momentum indicator used in forex trading that measures whether a security is overbought or oversold. The indicator consists of the %K line and the %D line.
The %K line is crucial because it measures the current price level relative to the previous high/low range, and the %D line is a moving average of the %K line, which is then used as a signal line.
Overbought and oversold levels are typically 80% and 20% respectively, which means that if the %K line is above 80%, the security is considered overbought. If it is below 20%, it is considered oversold. Remember that you can adjust these levels to suit your trading strategy.
How to use the stochastic indicator
Traders can use the stochastic indicator in several different ways, but perhaps the most common is looking for divergences. A bullish divergence is when the price makes a new low, but the stochastic indicator does not, which signifies that the downtrend is losing momentum and that a reversal may be on the cards.
A bearish divergence happens when the price makes a new high, but the stochastic indicator does not and is seen as a sign that the uptrend is losing momentum and that a reversal may occur in the future.
Another way to use the stochastic indicator is to look for crossover signals. A bullish crossover is when the %K line crosses above the %D line, seen as a buy signal. A bearish crossover occurs when the %K line crosses below the %D line, which is seen as a sell signal.
Traders can also use the stochastic indicator to generate overbought/oversold signals. As we mentioned earlier, if the %K line is above 80%, the security is considered overbought, and if it is below 20%, it is considered oversold. You can change these levels to suit your trading strategy, but they are a good starting point.
Benefits of using a stochastic indicator
There are several benefits to using a stochastic indicator in your trading.
Firstly, it can help you identify potential reversals in the market because divergences and crossover signals are often seen as leading indicators of reversals.
Secondly, the overbought/oversold levels can be used to generate buy/sell signals.
Thirdly, the stochastic indicator is relatively straightforward to use and interpret, making it a good choice for beginner traders.
Disadvantages of using a stochastic indicator
There are also several disadvantages for traders using a stochastic indicator. The main disadvantage is that the stochastic indicator is lagging, which means that the move may already be over by the time a signal is generated, which means there is a risk of entering into a trade too late and missing out on some of the moves.
Another disadvantage is that false signals can occur from time to time. These false signals are why it is always essential to use the indicator with other technical indicators and price action analysis.
The stochastic indicator is a prevalent technical indicator that traders can use in several ways. The most common way to use the indicator is to look for divergences or crossover signals. Traders can also use the indicator to generate overbought/oversold signals. Whatever you choose to use the stochastic indicator, make sure that it fits your overall forex trading strategy.
Suppose you are a beginner trader in the UK. In that case, we recommend using an experienced and reliable online broker and trading on a demo account to get the hang of opening and closing trades first.