If you want to time your trading signals with great accuracy then you need momentum indicators and if you are looking for one of the best look no further than the stochastic. It is an essential indicator for all traders serious about making bigger profits so let’s look at it.

Why is it such a vital indicator?

Quite simply, it gives you advance warning of shifts in price momentum near important turning points allowing you enter the market with great accuracy for bigger profits.

An Introduction

George Lane, who developed the stochastic indicator, concluded that in an up-trend, prices tend to close near their high, and in a down-trend, prices tend to close near their lows.

The further the price closed away from the low or high the stronger the trend was likely to be.

We have all seen this in forex markets and this simple observation was the basis for the stochastic indicator.

The stochastic indicator therefore is:

A momentum oscillator that can warn of strength or weakness in a currency in advance making it a great leading indicator to confirm trading signals against chart support or resistance.

The Technical Bit!

Don’t worry if you don’t understand how the equation works – it’s a visual indicator and you can simply look for the set ups on most major chart services so the math’s below is only for those of you who really want to know – for the rest of you skip it and move to the next paragraph.

The stochastic is plotted as two lines %K, a fast line and %D, a slow line.

The %K line is more sensitive than %D

The %D line is a moving average of %K.

The %D line triggers the trading signals.

The way the stochastic is plotted is actually very similar to the way a moving average is plotted.

Just think of %K as a fast moving average and %D as a slow moving average.

The lines are plotted on a 1 to 100-scale.

"Trigger" lines are normally drawn on stochastic charts at the 80% and 20% levels.

A signal is generated when the lines cross.

The zones above and below these two lines are referred to as stochastic bands.

Overbought and oversold levels.

The 80% value is used to show when prices are overbought and, the 20% value is used to indicate when prices are oversold.

The Stochastic generates signals in various ways and the two below are very effective:

1. Overbought Oversold

When the 20% and 80% trigger lines are crossed the following action is taken.

Buy when the stochastic moves below 20% and then rises above that level and sell when the stochastic rises above 80% and then falls back below this level.

2. Stochastic Crossovers

Crossovers are very effective.

Buy when the %K line rises above the %D line and sell when the %K line falls below the %D line. You need to be cautious of short-term crossovers that may generate "false" signals.

The best crossover is when the %K line intersects after the peak of the %D line (known as a right-hand crossover).

3. Stochastic Divergences

Divergences between the stochastic and the underlying price trend also offer good signals to trade and are a great leading indicator for entering positions.

If prices are making a series of new highs and the stochastic is moves lower or crosses then you have a warning sign that price momentum is weakening and a top may be at hand and vice versa in a bear market.

Combining the Stochastic With Other Indicators

The stochastic is probably the best momentum indicator and can work with just support and resistance on your forex charts. It can also be combined with other momentum indicators to filter false signals and the Relative Strength Index is ideal for this.

If you want to improve your forex trading strategy and time you’re trading signals with great accuracy, take a look at the stochastic indicator and you will improve your chances of currency trading success.