The Stochastics Indicator Explained in Forex Trading

The Stochastic Indicator has been in use since the 1970’s, the originator of this indicator by the name of George Lane observed that as price rises in an uptrend, the closing prices tend to close near the upper end of the candles or bars.

In a down trend they tend to close near the lower end of the candles or bars.

The Stochastic indicator recognize the relationship between the closing price and the high and low of a bar and is typically used to identify when the market is overbought or oversold. It is scaled between 0 and 100 with readings above 80 indicating the market is overbought and readings below 20 indicating the market is oversold.

Forex traders recognize trading opportunities when the faster K line crosses the slower D line and enter or exit trades when the cross occurs after the market has been overbought or oversold.

It is also useful for identifying divergence which occurs when the market is making new highs lows but the indicator is not in agreement.

Trading with the stochastic indicator

If we look at the stochastic indicator tutorial chart which demonstrates a 1 hr eur/usd chart we can identify 4 overbought situations above the 80 line and 4 oversold situations below the 20 line. Each area represented a trading opportunity which roughly interpreted means we sell the overbought areas and buy the oversold areas.

We have also identified a bullish divergence and three bearish divergence areas which in each case resulted in a correction or reversal of the current trend.

We do not enter a trade simply because the market is overbought or oversold as the situation can occur for an extended period of time. As we can see on the orange shaded area of the chart had we entered short at a price of 1.4235 when the indicator became overbought it would have not been a good trade as price continued to rise for many hours before turning short.

A bit of patience is required before entering a trade off the overbought or oversold areas. Once the faster K line (Green on chart) crosses the slower D line (Red on chart) and the lines cross back above or below the overbought (80) line or the oversold (20) line then we can enter a trade. This would also be the area to exit existing trades as a correction or reversal is possible from this point.

As we can see from the stochastic indicator tutorial chart all the trades off the overbought/oversold (red and blue arrows) areas resulted in reasonable trades.

The stochastic signal can be weakened or strengthened according to the time frame or instrument we are trading which will result in a more sensitive or less sensitive signal according to our own preferences.

Once we have identified that divergence is occurring we again wait until we have a valid cross of the K and D lines before entering a trade. The divergence gives an early warning that price is likely to reverse or correct in the near future and we can prepare to take the necessary action to benefit at the start of the new trend.