The world of Forex trend analysis uses many technical indicators and Stochastic is one of them. The Stochastic Oscillator was developed by George Lane in the 1950s and has since become an essential tool for comparing the current currency price with the most recent highs and lows.
To understand how a Stochastic Oscillator works, let's take Stochastic (7) for example. In this case, it means the current position of the currency price is being defined by the analysis of the last 7 bars in relation to the corresponding high and low range of those 7 bars. 1 bar presents 1 day. So when the daily chart shows the Stochastic (7) being too close to the zero line, it means the current price has hit the all-time low level in the past 7 days. In case the same chart has its stochastic line close to 100, it means the current security price is at an all-time high in the last 7 days period.
According to the theory of technical analysis, the market is described to have been oversold if the stochastic line hits below the 20 point. If it hits above the 80 point, the market is described to have been overbought. However, you need to be careful not jump into conclusions. For instance, a stochastic line dipping below 20 does not always mean the market trend will reverse. It only serves to tell you that the currency price is close to the 7-day low. Your currency pair can unpredictably go down during the whole of the 7 day period or can stay flat only to dip on the 7th day and so on. Your currency can hit the 7 day low for various reasons but you can not be assured your stock will soar as a result.
Is Stochastics reliable after all?
The unpredictable swing does not mean Stochastics is an unreliable technical indicator for your Forex strategy. All you need to do is to know what it leads and how to use it. You need to carefully monitor the indicator once it gets above 20 after having a stint below that mark and when it gets below the 80 point after it has stayed above it for some time. This is a better way of making concluding than simply making judgments once it drops below 20 or soars above 80.
A stochastic crossing the 20 point means that the currency price has just started rising after hitting the bottom but that does not mean it will keep that trajectory. At least, it shows that market sentiments have changed since hitting the bottom.
One last thing …
Just like other indicators, remember to pay attention to your currency pair's volatility because indicators tend to rely on it. Furthermore, it is prudent to use this indicator alongside others. The fact that Stochastics is based on price means you should consider using it in combination with a volume based Forex technical analysis.