In recent years, more and more finance workers have been turning to the foreign exchange market to generate an income. The potential for significant financial gains appeals to those looking for a career change or a second job, but only a few make the transition successfully.
This article will discuss using a popular technical indicator called stochastic to give you an edge when trading on the forex market. Be sure to familiarise yourself with ways to make consistent profit too.
Hone your technical analysis skills
The first step that should be taken by anyone interested in trading currencies is to hone their technical analysis skills. Stochastic indicators are just one of many tools that traders rely on. They do not guarantee results of any kind – it is essential to understand how technical indicators work before risking money on the forex market. Many free resources can be used to hone these skills.
Calculating stochastic indicators
To calculate the Stochastic indicator for any given time frame, choose a %K and %D line. For example, if you were to use 14-periods of %K and 8-periods of %D (this is known as Fast Stochastic), then it would look like this on an MT4 platform:
The stochastic oscillates between 0% and 100%, with the upper bound representing overbought conditions while the lower bound represents oversold conditions. The signal line is not included in this calculation; instead, traders must study the chart to determine where it should be drawn. We will touch upon this further down.
How do they predict price movement?
Now that we have some basic knowledge of how stochastics work, we can delve into how they can predict price movements. In a bullish market, the upper bound of stochastic will usually appear around 80 or 90%, while in bearish markets, the lower bound of stochastic will usually appear around 20 or 10%.
In a bullish market, prices will sometimes overshoot and become overextended on the high side (when compared to the previous movement) before falling back down and becoming undervalued again. The opposite happens in bearish markets.
Modified stochastic strategy
One of the most commonly used oscillators is the standard stochastic indicator which plots %K (higher %K numbers reflect increasing price momentum) over %D (lower %D numbers reflect increased selling pressure).
The standard interpretation is that readings above 80 reflect overbought conditions (where buying pressure is too high) and below 20 reflect oversold conditions (where selling pressure is too high). The stochastic indicator can be modified in several ways to help traders.
A common modification is simply plotting %K with %D rather than against it. It makes for a smoother-looking oscillator that changes direction more gradually than the standard version, returning more reliable entry signals when combined with other indicators. Using an alert or signal line for buy/sell confirmation
This strategy involves crossing the %K and %D lines to create a sell or buy signal. When the two crosses each other upward, this results in a bullish crossover, often called a golden cross.
A downward crossover would create a bearish crossover or a dead cross. If the %K and %D lines are moving in opposite directions, there is no signal created for that given period. However, if they both move in the same direction, it will indicate an up/down movement that can be used to confirm buying or selling.
Using different periods
The standard stochastic indicator uses the past 14 days to calculate %K and %D, so it lags behind price action by at least 14 bars. Optimising your time frame to ensure you’re getting reliable signals from stochastics will help increase your success rate when trading with this tool.
The shorter the time frame you use, the more recent your data will be and, therefore, less likely to form false signals. For example, using daily data with 5, 6 and 9-period stochastics will give you different results for each timeframe.
Using a stochastic indicator successfully involves reading technical analysis books or blogs on the subject. You need to understand why it works to recognize when it’s not working and backtest your strategy until you find one that is reliable.