The stochastic measures the velocity and speed of price and divergence of the stochastic from the price trend, can warn of reversals in both trends and range bound markets.

Range Bound Markets

The following set ups are often used by currency traders to generate currency trading signals

Long Trading Signals

1. Take a long on bullish divergence (on %D) where the first trough is beneath the Oversold level.

2. Take a long when %K or %D falls below the Oversold level and rises back above it.

3. Take a long when %K crosses to above %D.

Short signals:

1. Take a short on bearish divergence (on %D) where the first peak is over the Overbought level.

2. Take a short short when %K or %D rises above the Overbought level then falls back below it.

3. Take a short when %K crosses to below %D.

Trending Markets

Only take signals in the direction of the prevailing trend and never go long or short when Stochastic is at overbought or oversold levels.

The shape of a Stochastic bottom can you give you some warning signs of what to expect in terms of price action.

A narrow bottom that is not to deep indicates that bears are weak and any rally if its confirmed should be strong. A broad, deep bottom shows the bears have control and that the rally is likely to weak. The same applies in reverse at Stochastic tops. Narrow tops indicate that the bulls are weak and that the correction when it comes, should be strong. High and wide tops indicate that the bulls are in control and the correction is likely to be weak.

Conclusion

This is a brief introduction on how to generate trading signals with the stochastic and while it is a powerful indicator, it needs to be combined with other filters / indicators and if you choose the right ones, the stochastic can be a fantastic indicator to gain better market timing with your trading signals. You will find more background to the stochastic and the calculation in other articles on this site.