Another technical indicator that might help traders predict where a trend will terminate is the Stochastic oscillator.
The oscillator operates according to the following theory:
- 1. During an uptrend, prices will remain equal to or above the previous closing price.
2. During a downtrend, prices will likely remain equal to or below the previous closing price.
How to Trade Forex Using the Stochastic Indicator
When the market is overbought or oversold, the Stochastic technical indicator notifies us. The Stochastic scale ranges from 0 to 100.
When the Stochastic lines (the red dotted line in the chart above) are over 80, it indicates that the market is overbought.
When the Stochastic lines (the blue dotted line) fall below 20, it indicates that the market is probably oversold.
As a general guideline, we purchase when the market is oversold and sell when it is likely overbought.
The currency chart above shows that the indicator has been indicating overbought circumstances for quite some time.
Can you predict where the price will go based on this information?
If you predicted that the price will fall, you are totally correct! Because the market had been overbought for so long, a reversal was unavoidable.
That is the fundamentals of stochastic.
The Stochastic is used in a variety of ways by forex traders, but its basic purpose is to show us where the market conditions may be overbought or oversold.
Remember that Stochastic can remain above or below 20 for extended periods of time, so just because the indicator shows “overbought” doesn’t mean you should sell!
Similarly, if you notice “oversold,” that doesn’t imply you should immediately start buying!
Don’t be a Stochastic Sheep.
Next Lesson: How to Use RSI (Relative Strength Index)