It is a common trend to use a momentum indicator like stochastic oscillator to pinpoint potential trend reversals in Forex trading. Stochastic oscillator measures momentum by comparing the closing price to the trading range over a period of time.
On the chart, stochastic oscillator is represented by two lines. There is the %K which is the indicator itself and the %D which a signal line representing a three-day SMA (simple moving average) of the %K.
When a trend shift is approaching, these two lines may intersect. The signal line may appear to have a downward cross when the most recent closing price seems close to the lowest low compared to how it has been in the last three sessions. There could also be sudden drop to the trading range lower end after a sustained upward price action to indicate loss of steam in case of a bullish trend.
Stochastic Trading Divergences
When the prices seem to be going in one direction, divergence will appear. In which case, the oscillator takes a different direction. When the two move in opposite directions, they diverge.
Forex trader trust oscillators because they use multiple periods to plot a value. For the bullish divergence, you should keep an eye on the price especially when it makes two consecutive lower lows, and check to see if the stochastic oscillator confirms the second low.
In a bearish divergence, the price is likely to make two successive higher high and the stochastic oscillator will probably not conform the second high.
Adapting the Money Management System Using Stochastic Indicator when Trading
In most cases, the currency market tends to spend time during the consolidation periods. Hence, forex traders are forced to wait for next session to assess what next. in such case, a risk-reward of 1:2 seems too big especially when using stochastic to trade on bigger timeframes.
During summer or holidays, the price actions tend to stall. In which case, even waiting for that 1:2 ratio seems useless. Even when the price reaches the take-profit level eventually, other adjacent costs affect the account.
In such conditions, consider using a conservative approach. Taking few steps to protect your trading account is crucial. Always wait for the price to be at 1:1 ratio to measure the risk and value it forms an entry-level while you wait for the price to reach the ratio. Or you could book half your position at 1:1 while moving the stop-loss till it breaks even. This will make the margins available for new trading opportunities.
We recommend having another signal pointing to the same direction when trading with stochastic indicators. This is a helpful confirmation because it acts as a reinforcement for your trading idea.
Remember divergences form either at the tops or bottoms so always look for reversal chart patterns because they take as little time to form ass possible. Consider using Japanese candlesticks when trading with stochastic because they will help you look for a shooting star, hammer, engulfing, piercing, morning or evening stars, etc.
You should also consider using stochastic oscillators even on lower timeframes especially if you prefer scalping. By going in and out of the Forex market for a quick profit is important because it help you avoid emotions and further cost of maintaining a trade open overnight.
You should also keep an eye on low high series especially in bearish trends because lower lows and lower highs series are decisive. In such a trend, if the indicator moves above 50, there is an exit from the previous short trade. However, when it crosses above 50, the lower high series failed to break and the trend will remain in place. In such cases, wait for the stochastic oscillator to turn.
Trading with stochastic oscillators follow the same path as other trading oscillators in Forex. It especially offers much help in determining the overbought and oversold levels. Stochastic oscillators also work with bullish and bearish divergences especially on shorter and longer timeframes.
Trading with stochastic will also be of assistance if you use it as a trend indicator because it travels between overbought and oversold levels. This puts you at a possibility of a profit if they cross the middle line.