Stochastic - Using the Stochastic Indicator

The stochastic forex indicator is a type of oscillator used by many traders in their forex trading analysis.

This indicator's primary function is to determine the momentum of the markets. There are three types of stochastic oscillators that most people use on a daily basis. They are the fast stochastic, slow stochastic and the full stochastic.

They all work in a very similar way. However, it should be noted that when traders refer to the stochastic forex indicator, they are usually talking about the slow stochastic.

The stochastic indicator works on the premise that prices for a financial instrument tend to close in the upper trading range when that instrument is in an up trend.

Conversely, prices tend to close in the lower trading range when the instrument is in a down trend.

When this happens it is usually a sign that momentum is still strong. Visually, the stochastic indicator is represented by two lines. They are the %D and %K line.

This indicator is a banded oscillator which makes it somewhat similar to the RSI forex indicator. The %D and %K lines fluctuate within a range between a value of zero to a hundred. Extreme ends of this range is represented by two straight lines at 20 (Extreme low) and 80 (Extreme High).

Forex traders use the stochastic indicator to identify oversold and overbought conditions. In that respect, it is again very similar to the RSI indicator. Should the indicator breach the 80 line, this is a sign that conditions are overbought. If the indicator breaches the 20 line, this is a sign that the instrument is oversold.

Forex traders also use the stochastic oscillator to determine if market momentum is weakening. This is indicated when the indicator is trending in the opposite direction of price.

Cross over strategies are also common with stochastics. Traders watch for the faster %K line to cross over the slower %D line. Should it cross above the %D line, this is an indication that it may be a good time to buy. If it crosses below the %D line, the reverse is indicated.

It should be noted that like moving averages and the relative strength index, the stochastic indicator does not perform that well when the markets are side trending. As such, it is used in conjunction with other indicators and strategies for its true benefit to be gained by the forex trader.