The stochastics indicator is similar to the relative strength indicator in that it measures the momentum of the market and can warn as to when a market is perceived to be overbought or oversold. Any reading above 80 is considered overbought and below 20 is considered oversold.
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Swing traders use the stochatic indicator to buy when the indicator is showing that the market is oversold and sell when the indicator is showing that the market is overbought. This follows the idea that price moves in waves, and a trader should wait for a pullback (entering overbought/oversold) before entering a trade.
In addition to warning of possible overbought and oversold areas, the stochastics indicator can be used to monitor the momentum of a market. If price continues to climb higher, but the stochastic indicator fails to make higher highs, it may be a warning that the market is running out of momentum and is preparing to undergo a pullback or retracement.
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The screenshot above shows price climbing higher making new highs. However, the stochastics indicator is making lower highs. This is a clear sign that the market may be running out of momentum and preparing to pullback or retrace.
Stochastics, like any indicator, is not perfect. One should never enter a trade blindly using the stochastic indicator. Instead, any signals given by the stochastic should be confirmed with either price action or support and resistance levels.
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