Stochastic Indicator Explained

The Stochastic indicator is one of the most popular indicators as it’s very widely used by the majority of traders. Stochastic is actually a technical indicator used to measure overbought and oversold conditions in the market. However, there is another application which is really more for trend traders and momentum. Stochastic is actually a Greek word for “random”. Typically a reading above 80 line is a sign of overbought conditions in the market, while a reading below 20 line is a sign of oversold conditions in the market. There are three different types of stochastic oscillator:

1. The Fast Stochastic;
2. The Slow Stochastic;
3. The Full Stochastic;

All of these operate in the same manner, however, the most traders refer to the Stochastic they are talking about the slow Stochastic and going forward we’re going to focus on this indicator. The basic premise of a Stochastic indicator is that prices tend to close in the upper end of their trading range when the financial instrument that you analyze is in an uptrend; and at the lower end of their trading range when the financial instrument that you analyze is in a downtrend. The Stochastic oscillator moves between 0% and 100% and the term stochastic refers to the location of the current price in relation to its price range over a period of time and basically what this method does is that it attempts to predict price turning points by comparing the closing price of the trailed currency pair to its price range. The Stochastic oscillator is made of two components:

1. %K line – Represents the raw measure used to express the idea of momentum behind the oscillator.
2. %D line – Represents a simple moving average of the %K line.

How to use the Stochastic Indicator

Unlike other oscillators, the Stochastic indicator is used as a primary tool to spot overbought and oversold conditions in the market even though it can be used to spot divergence and also it can be used to generate signals when the %K line crosses the %D line. Since it’s mainly used to spot overbought and oversold conditions in the market when the stochastic line moves into the “overbought” territory of the scale (80 or above) it signals exhaustion of the trend and the likelihood of at least a retracement of the prevailing trade if not a full reversal and shorts are favored. On the other hand, when the stochastic line moves into the “oversold” territory of the scale (20 or below) it signals exhaustion of the trend and the likelihood of at least a retracement of the prevailing trade if not a full reversal and longs are favored. Since the Stochastic indicator isn’t really designed to follow price and volume, it’s designed to follow the momentum. As a rule momentum will change direction before price does so in this regard trader use this indicator to spot divergence where price is moving in one direction and momentum is moving in another direction. Even though the Stochastic indicator performs better and gives you more accurate overbought/oversold conditions when we have range market environment, the Stochastic indicator can be also used when we have a trading market. In an uptrend we’re most likely going to stay in “overbought” territory for an extended period of time in this regard waiting for “oversold” conditions on lower time frame to buy the market is a much better proposition. In reverse the same thing is true when we’re in a downtrend.