Another technical indicator that traders use to determine where a trend is likely to terminate is the Stochastic oscillator.
The oscillator is based on the following principle:
- Prices will remain equal to or above the prior closing price during an uptrend.
- Prices will most likely remain equal to or below the prior closing price during a downtrend.
George Lane invented this simple momentum oscillator in the late 1950s.
To predict the continuation of the present direction trend, the Stochastic oscillator utilizes a scale to evaluate the degree of difference between prices from one closing period to the next.
In the same way that the MACD lines are faster than the other, the two lines are similar.
How to Trade Forex Using the Stochastic Indicator
When the market is overbought or oversold, the Stochastic technical indicator notifies us. It is a number that ranges from 0 to 100.
The market is overbought when the Stochastic lines are over 80 (the red dotted line in the chart above).
Stochastic lines below 20 (blue dotted line) are likely to indicate an oversold market.
As a general rule, we buy the oversold market and we sell the overbought market.
If you look at the currency chart above, you can see that the indicator has been overbought for quite some time.
Can you predict where the price will go based on this information?
You are definitely correct if you predicted that the price would fall. A reversal was unavoidable because of the overbought market.
The fundamentals of stochastic are as follows. Forex traders use it in a variety of ways, but the fundamental objective of the indicator is to show us where there is the overbought or oversold market.
Remember that Stochastic can stay above 80 or below 20 for extended periods of time, so just because the indicator shows “overbought” doesn’t mean you should sell blindly!
Similarly, just because something says “oversold” doesn’t mean you should start buying right away!
Be a Stochastic Sheep, not a Stochastic Sheep!
With practice, you’ll be able to tailor the Stochastic indicator to your particular trading strategy.
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