The Foreign exchange market is highly liquid and continuously fluctuating. In order for a person to make money out of the same one must determine what and when an upward or downward trend will occur and act on it as soon as the same occurs. One way to read thru the steady stream of raw data is via stochastic indicators.
What are Stochastic Indicators?
Also known as stochastic oscillator it is a foreign exchange concept that makes use of support and resistance in order to determine momentum. The rationale or rather the inspiration for the same came from George Lane who observed that when prices rise to their peak or fall at their absolute bottom they tend to slowly move back the opposite direction or back to the middle. This can then be used to determine an overbought or oversold condition. The same is referred to as an oscillator because of the fluctuation in values (0 to 100).
What is Overbought?
This refers to a situation where in the value of a security and/or the underlying asset rises to extreme levels or becomes overvalued. The current value does not support fundamentals; hence the same is likely to result in a pullback of prices. This results in a sharp rise in the graph and then the inevitable drop.
What is Oversold?
The opposite of overbought, in that the value of the security and/or the underlying asset drops and becomes undervalued. This results in low demand hence a sharp decrease in price. However, when it goes low enough demand for the same stirs up, hence the value slowly rises back to equilibrium.
Why are Stochastic Indicators so Popular?
There are many things going for this particular type of oscillator. First, is the simplicity of the same. Second is the soundness of the principle based on simple logic that what goes up must come down and vice versa. Third, is its relative effectiveness in determining turning points prior to and/or immediately upon their occurrence. Before making a trading decision, it is recommended that you first try out several combinations of indicators until you find the perfect formula for your trading style.
How to Read Stochastic Indicators?
The simplest way to explain the same is to think of a graph. The vertical line refers to price, which is scaled from zero to 100 while the horizontal line refers to periods (time). There are usually three lines (red, green black). When the Stochastic lines go above 80 the market is overbought. When the Stochastic line goes below 20 the market is oversold.