Overbought and Oversold Levels

The main way to use Stochastic as signals is to look for overbought conditions at the 80% level and oversold conditions at the 20% level. The key is not to look just at when the %K or %D lines touch or cross overbought/oversold, but when they cross over and back through these levels. As with other momentum oscillators (such as RSI) the readings can stay inside the overbought and oversold levels for some time. When the lines cross back below or above the levels it is usually a good indication of an upcoming reversal.

One can look for further signs to make Stochastic's overbought or oversold levels more reliable if:

• Before Buying, one sees the %K and %D lines turn upward from below 5%.
• A Stochastic reading that is hovering near 5% means that sellers are in control and there is distribution (selling) of the currency pair. A technical trader would wait for the reading to move back above 5% as a sign that distribution is easing.
• Before Selling, one sees the %K and %D lines turn down from above 95%.

When Stochastics hovers near 95% that means that buyers are in control of the market and there is accumulation. A technical trader would wait for the reading to move back below 95% as a sign that accumulation is easing.

A Note on Periods

Looking at different time frames when using overbought and oversold levels can also help to determine correct entry strategies. The main principle is to “trade with the trend.” It is prudent to check longer term stochastic readings as a short term graph may mislead a trader.

• A trader takes on more risk if he buys into a market that has a longer term overbought reading.
• A trader faces similar risk if he sells into a market that shows oversold levels in a longer tem chart.
• This can be especially true if the price is pushing up against support or resistance levels.

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