About the Stochastic

The stochastic is a momentum indicator that helps us identify a change in price direction and can also give us entry signals to buy or sell. This oscillator basically follows the speed or momentum of price and shows overbought and oversold conditions in the market.

The stochastic indicator actually consists of two lines. The first line (often called %K) is the stochastic itself and the second line (called %D) is basically the moving average of the stochastic (the %K line). Don’t forget that on the MT4 trading platform the main %K line is displayed as a solid line and the %D is a dotted line.

The stochastic indicator is plotted on a vertical scale between 0 and 100. A reading below 20 indicates an oversold condition whereas a reading above 80 indicates an overbought condition.

On the chart you can see that after the stochastic shows an oversold situation, prices go back up. After an overbought situation prices go back down.

Trading with Stochastics

An overbought condition suggests the possibility of an upcoming pause in a market rally, as buying pressure runs out of steam. So there is a greater potential for a reversal in price direction. Awareness of this situation can help us time a good selling opportunity. Conversely, an oversold condition suggests the possibility of an upcoming pause in a market decline as selling pressure runs out of steam and makes a reversal to the upside more likely. Awareness of this situation can help us time a good buying opportunity.

Divergence

Bullish and bearish divergence signals between price action and the stochastic oscillator are also helpful signals when anticipating market pauses and changes in price direction. A bearish divergence forms when a price records a higher high, but the stochastic oscillator forms a lower high. This shows less upside price momentum that could eventually lead to a downturn in prices.

On the other hand, a bullish divergence forms when a price records a lower low, but the stochastic indicator forms a higher low. This shows less downside price momentum that could signal a reversal.

Below we have an example of bullish divergence. Prices are falling but the stochastic is rising. Consequently, prices soon halt the downtrend and rise back up.

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