A stochastic indicator refers to technical oscillators that are used to identify the level, at which trend is likely to end. As a rule, it works on the two major concepts. The first one considers that the price will move above its closing level or at least remain the same during the uptrend. According to the second concept, the price is going to be equal or go below the closing rate during the downtrend.
Created during the 1950s, this indicator is very simple to read. If you are new to this oscillator, this article will show how to use a stochastic indicator under real market conditions.
What Is a Stochastic Indicator?
It is generally used to measure the degree of the price change with one closing point on the one hand and the current direction on the other. It helps to understand how the trend will move and if it is going to change the direction.
The indicator depicts two lines that are equal to those we have already seen in the MACD chart. It is supposed that one line moves faster than the other one. So, you need to understand how to read the indicator properly.
How to Read the Stochastic Indicator
It comes with a scale from 0 to 100. Just as other range-bound oscillators, a stochastic indicator makes it possible to identify the periods when the market is overbought or oversold. To read it properly, you need to keep in mind the following:
- If the indicator reading scales over 80, it means that the market has reached its overbought conditions;
- If the indicator is below 20, the indicator says that the market is oversold.
Besides, we need to note that the indicator uses baseline 14-period settings. In other words, it does not matter where it scales. The price movement changes in accordance to its trading range over the last 14 periods.
Note: the oversold market reading does not always mean bullish. The same way, oversold conditions are not necessarily bearish. The indicator may stay on the same scale for a long period. You still need to follow the trend direction during trading and keep an eye on the overbought readings during the downtrend and vice versa.
Stochastic indicator is avalable at MetaTrader 4. Download it for free!
Tips to Trade Using a Stochastic Indicator
On default, traders are used to buying assets once the market has reached the oversold condition or sell when it is overbought. On the other hand, if the market stays in the same condition for a long time, an unexpected reversal is bound to happen.
The key challenge here is to predict the best moment to enter or exit the position. This is where divergence must be taken into account as well. It makes it possible to determine the trend's tops and bottoms letting traders decide on the best entry or exit position. What's more, divergence can be used the way the price will act in the future.
We are used to the fact the price generally moves the same direction as indicators. Divergence is the term that defines a moment when the two are not able to move simultaneously resulting in lower lows or higher highs. In other words, we are witnessing the process of divergence along with the price and indicators diverging from each other.
Example: imagine reading a chart that depicts a bullish divergence on the currency pair. Let's consider the price is making lower lows and the indicator fails to follow the same direction. It shows higher highs instead. This is the example of how they can diverge one from another resulting in the price that starts a new uptrend featuring a changed downtrend when compared to the previous closing.
The Bottom Line
A stochastic indicator is one of the most commonly used oscillators within the trading community. It is pretty easy to read, as it consists of two lines that generally show the market overbought and oversold conditions. But the trick is that some traders use it to define the divergence between the indicator and the way price acts.
In other words, we have another flexible instrument that can be customized and integrated with a specific trading strategy. You can actually adapt it to your personal trading style. However, you should also consider huge risks. The tool may come up with false signals as well as some other types of oscillators. So, make sure you have a signal confirmation before opting for the entry or closing market position.
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.