One of the reasons why the Stochastics indicator is popular among forex traders is its success in identifying overbought and oversold prices. When a currency price is overbought, it means that it is overvalued because of high market sentiment, and a correction may soon be due that would cause the price to go down. On the other hand, if it is oversold, the price is undervalued because of reasons like panic selling. Again, if this is the case, the price will be due for a reversal. When traders see these conditions, they also see an opportunity they can take advantage of to make a profitable trade.
When the Stochastics indicator shows that a currency is oversold, all the trader has to do is wait for signs of a reversal, and then buy the currency in expectation that it would continue to go up. On the other hand, if the currency is overbought, the preferred strategy is to short sell it, meaning that you will sell currency that you borrowed from your broker when the price is high, and then buy it again when the price goes down and pocket the difference as your profit.
When you are using the Stochastics indicator, most analysts suggest that traders supplement it by using a complementary indicator, such as the MACD (Moving Average Conversion-Divergence). The MACD is used to determine price trends by taking the difference between two moving averages of a longer and shorter length, and then determining the direction of price trends by looking at which direction the MACD crosses the signal line. If the MACD crosses above the signal line, it signals a bullish market while if the opposite happens, it is a bearish market. A bullish market indicates that the price will go up while a bearish one means that prices will go down.
There are more favorable times of day to use the Stochastics indicator when you are trading. Analysts recommend that you use this oscillator during the later hours of the trading day, since the market is at its most volatile in its first few hours, when key economic data is released and the markets are reacting to it. For example, if you are trading in the Asian markets, you should keep in mind that the Tokyo Stock Exchange is open from 7PM to 4AM EST so you should avoid starting your trades an hour or so before the markets open. During this time, the possibility of price breakouts is at its highest and new trends may develop. Afterwards, traders can apply the oscillator since the trends may then reverse.
Traders should also use their forex calendars to avoid using the Stochastics indicator during times of high volatility. Some of the economic developments that can cause volatility in the currency markets include announcements of interest rate hikes, the Gross Domestic Product and the Consumer Price Index that measures changes in the prices of basic goods and services. Again, traders using the Stochastic oscillator should avoid trading when these economic news developments break since new support and resistance levels may be set.
