How to Use the Stochastic Indicator

2 min

The Stochastic oscillator is another technical indicator that helps traders determine where a trend might be ending.

The oscillator works on the following theory:

  1. During an uptrend, prices will remain equal to or above the previous period closing price.
  2. During a downtrend, prices will likely remain equal to or below the previous closing price.

This simple momentum oscillator was created by George Lane in the late 1950s.

Stochastics measures the momentum of price. If you visualize a rocket going up in the air – before it can turn down, it must slow down. Momentum always changes direction before price.

The Stochastic oscillator uses a scale to measure the degree of change between prices from one closing period to predict the continuation of the current direction trend.

The 2 lines are similar to the MACD lines in the sense that one line is faster than the other.

Stochastic - Forex Chart Analysis

How to Trade Forex Using the Stochastic Indicator

The Stochastic tells us when the market is overbought or oversold. The Stochastic is scaled from 0 to 100.When the Stochastic lines are above 80 (the red dotted line in the chart above), then it means the market is overbought.

When the Stochastic lines are below 20 (the blue dotted line), then it means that the market is oversold.

As a rule of thumb, we buy when the market is oversold, and we sell when the market is overbought.

Stochastic overbought - Forex Chart Analysis

Looking at the currency chart above, you can see that the indicator has been showing overbought conditions for quite some time.

Based on this information, can you guess where the price might go?

Forex Chart Analysis - Price drops after Stochastic hit overbought

If you said the price would drop, then you are absolutely correct! Because the market was overbought for such a long period of time, a reversal was bound to happen.

That is the basics of the Stochastic.

Many forex traders use the Stochastic in different ways, but the main purpose of the indicator is to show us where the market conditions could be overbought or oversold.

Over time, you will learn to use the Stochastic to fit your own personal forex trading style.

Okay, let’s move on to RSI.

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