The Stochastic is a two-line oscillator plotted on a scale of 0 to 100 that measures overbought and oversold conditions in the market. Traders generally use it to determine
When the stochastic lines are below 20, the market is oversold.
When the stochastic lines are above 80, the market is overbought.
In general, traders use oversold conditions as a buy signal and overbought conditions as a sell signal. What you have to do is wait until either the fast line (%K) or the slow line (%D) reaches extreme conditions (above 80 or below 20) and once the indicator changes direction, enter a new trade.
The crossing of the lines also provides a signal: the fast line reacts to price changes more quickly than the other. This line tends to give earlier warnings that price is becoming overbought or oversold. As a consequence, when it crosses the slow line, you can take that as a signal to enter a new trade.
Stochastic signals will never be 100% correct, as with any other technical indicator. False signal will occur, but overall the signals are consistent enough to give you an “edge”.
RSI is another popular oscillator, widely appreciated because of its clarity and the straightforward signs that it generates. In contrast to the Stochastic, the RSI only has a single line, plotted on a scale from 0 to 100. Readings over 70 are considered overbought, and under 30 – oversold. Breaches of these levels can be used to enter new trades, similar to the Stochastic.
The RSI is also a very useful tool for timing your exits from the markets, in order to take maximum profit ahead of a rise or fall in price.
The 50 Level – one way of using the RSI is plotting the 50 level to identify the balance between buying and selling power. Here is an example where the RSI Line is below the 50 level, signaling the presence of more sellers than buyers in the market.
Last but not least, the RSI can be used to indicate divergence. A discrepancy between the RSI oscillator and the current price action indicates that a market turning point is imminent. This is apparent in the chart below:
The AUD/USD was continuing to rally while the RSI was starting to turn downwards. This divergence provided a sell signal that forecasted a decline of more than 100 pips.
Keep in mind: each indicator has its imperfections. This is why you should combine different indicators and see where they converge.
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