How many technical indicators do you need to make a trading decision? Many traders fall victim to analysis paralysis and use too many signs. What you need to do is master only these two indicators; The Stochastics and the MACD (Moving Average Convergence Divergence. Both are called oscillators as their values oscillate between two extremes!
Why I say these two indicators are the best for you. Let me explain. Trending conditions in the market exist not more than 30-40% of the time. The rest of the time, the market is range-bound or what you call consolidating. After a nice trending move, the market will move in a consolidation phase.
In choppy range-bound market conditions, Stochastics is your best friend. And in trending market conditions Moving Average Convergence Divergence (MACD) will give you stable trading signals.
Now, the myth that MACD is the best indicator out there may not be accurate. The reason being market conditions change and the people’s perception of an index’s given value. There is no holy grail in trading. Under certain market conditions, Stochastics may be more useful as compared to MACD.
Stochastics is also known as a Momentum Indicator. This is a popular trading tool used to determine whether the market is in an overbought or an oversold condition.
Overbought means that the prices have advanced too far too soon and are due for a downside correction. On the other hand, oversold means that the prices have declined too far too fast and are scheduled for an upside correction.
Stochastics used a mathematical formula that shows the location of the current close as compared to the high/low of the range over a specified period. Closing prices near the top of the field show that buying pressure and closing price near the bottom of the range show selling pressure.
Now Stochastics uses two-line known as the %K and %D. These two lines are plotted on the chart for a given period. The %D is the three-period moving average of the %K line. Now %K is a ratio or percentage and fluctuates between 0 and 100. It is calculated with the formula that used the recent close, highest high, and the lowest low.
Now the %K line is the faster line and will change direction as the %D line is just the moving average of the %K line. The general rule is if the reading is over 80%, the market is overbought and ripe for a downside correction. And if the reading is below 20% on the chart, the market is oversold and ripe for bouncing down.