Developed by George C. Lane in the 1950's, the Stochastic Oscillator is a momentum-type indicator that traders use to identify overbought and oversold zones. Another indicator that does the same is the RSI (Relative Strength Index).
According to Lane himself, the Stochastic doesn't follow the volume nor the price, but the speed or momentum of the price. In short, this indicator helps traders determine when a trend might be ending.
The Stochastic Oscillator consists of two lines; one slower than the other. This is similar to the MACD. Read about it by clicking here.
If you take a look at the forex chart above, you can see circles in two different colours. The red circle is the oversold region, whilst the yellow is overbought. By default, the overbought and oversold zone are set to 80% and 20% respectively.
As a rule of thumb, when the market is oversold, one can expect the price to enter a bullish state (upwards). Similarly, when it's overbought, experienced traders typically sell. One can confirm this by adding the Moving Averages to the mix. Since the Stochastic consists of two lines (slow and fast moving averages), we normally ensure that both lines are either above the 80% or below the 20%.
Now, when the Stochastic enters either the overbought or oversold, does it mean that it will automatically switch directions ? No ! This indicator doesn't just show you when the price enters those regions. It's meant to show you the momentum. At times the price can remain above 80% and below 20% for long periods of time, signalling strong trends. This is when it's best to use the tool in tandem with another one, such as the ADX or moving average.
As you can see in the image above, the Stochastic was in the overbought for quite some time, and the price kept going up.
You can also get what's known as a Diversion. The price could be saying one thing, and the Stochastic saying the complete opposite. As example of this is a bullish trend on the price, but a downward movement on the Stochastic.
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