The Stochastic Indicator is an oscillator, which shows at the bottom of your chart.

Stochastic forex indicator displayed below

In this example we are using a 10,3,3 period setting. We have also set up two lines at 80 and 20. Now if you remember from the introduction to forex indicators section, the stochastic forex indicator is showing us overbought and oversold positions.

Overbought and oversold means…

The stochastic forex indicator measures how the market has been moving and displays whether or not it is deviating from recent history. So let us say that the market is moving steadily downwards like it is in the above chart.

As the market continues in that direction, the stochastic indicator is sitting between the 20 and 80 mark (the two lines we added) which is telling us that based on recent history this is an expected range.

If the lines go below 20, as it does about 1/3rd of the way in the above chart, it is telling us that the market has moved down too quickly. This is what we call oversold. When the stochastic forex indicator goes above the 80 mark it is telling us that the market has gone up too quickly compared to the recent history. We call this the overbought mark.

How do we use Stochastic to trade?

There are two things we can do with this forex Indicator. The first is used as confirmation as to whether or not it is okay to enter a trade. The second is as a potential entry.

I have highlighted an overbought and oversold position in the image below

Confirmation

When we use this as confirmation, it is basically telling us when it is too late to enter a trade. Imagine during the first oversold position, we also had a crossover with the 5 and 10 moving averages. The moving averages would tell us to enter a buy position, but the stochastic indicator is telling us that the market is overbought. This means it is too late, and we are expecting the market to reverse position soon.

If we see a short crossover happening when stochastic is oversold, it is telling us that the market has moved down too quickly already and it is too late to enter the trade. This is obviously not correct all the time. Nothing is. But you will find Stochastic can save you a lot of headaches!

Potential entry

A couple of times I have already mentioned that when the stochastic shows us that the market is in overbought or oversold we are expecting it to return to its usual direction, or at least turn around a bit. We can use that as a potential entry. But in this case, you cannot use it as confirmation as well so please don’t trade this on its own!

Stochastic forex indicator with overbought and oversold highlighted, and potential entries marked

In the above image we have added two red vertical lines. They are placed at the point that the stochastic indicator has left the overbought or oversold position. This is where the indicator is telling we expect the market to turn.

Obviously we have chosen two good examples and it is rarely this good. So we encourage you to open a demo account now and go test it out for yourself. Have a look at how it responds, and try it with a few settings.

As with all forex Indicators, the period setting is a balance. By changing the first value to a low setting you’re using a smaller amount of time. This would make the Stochastic Indicator respond a lot quicker, but it would also be faked out more often. A larger time frame.