The stochastic oscillator has a multitude of uses when it comes to trading Forex. We have already mentioned the most obvious use for the stochastic oscillator: the idea of identifying overbought or oversold conditions. In this scenario, the stochastic oscillator is best used in a range bound market, as it can tell you when to buy and sell in a relatively well defined situation.
When you look at the stochastic oscillator window at the bottom of the chart, you see the two moving averages going back and forth in an up and down pattern. You will notice that there are two lines in the indicator window including the 80 and the 20 level.
The area above the 80 level is considered to be overbought, while the area below the 20 level is considered to be oversold.Furthermore, you need to see the moving averages inside the stochastic oscillator to cross in the overbought or oversold areas in order to get a reversal signal. Anything between the two levels is essentially ignored in this scenario.
Looking at the chart, you can see that the stochastic oscillator had several moves back and forth between the 80 and the 20 levels. However, there are only a couple of areas where the indicator either broke into the overbought area or the oversold area and had a cross. You need both of these things to happen in order for it to fire off a signal.
In the graphic below, you can see that the signals fired off are color-coded by the arrows, with the red showing an overbought condition and a potential selling opportunity, and the blue showing potential buying opportunities in an oversold condition.
It should be noted that using the stochastic oscillator in this way is much more reliable when in a sideways market, preferably between significant support and resistance. This makes the stochastic oscillator truly important, because statistically speaking markets are in some type of consolidation or sideways action more than 70% of the time. In other words, it’s much more common to be in this environment than it is to be out of it.