(Please click on the accompanying chart to enlarge.)

Because I tend to use the Slow Stochastics a lot as a confirming oscillator for both swing trades and my daily Chart of the Day analysis, many traders have asked me how specifically I apply this very useful tool. Here, I would like to give a quick summary of how I view this multi-functional oscillator.

One way in which I use Stochastics is as a divergence indicator. Higher highs in price with lower highs in Stochastics, or lower lows in price with higher lows in Stochastics, provide divergence indications that hint at possible impending reversals.

More importantly, though, I use Stochastics to help confirm turns when swing trading. As shown on the accompanying chart, the red area between overbought and oversold is what I call “No Man’s Land.” This means that whether price is going up, down, or sideways in this region does not mean a thing to me. In other words, when Stochastics is in this region, I completely disregard anything the oscillator might be trying to tell me.

Likewise, when Stochastics has just entered overbought or oversold, or is reaching a peak or trough in the overbought/oversold territories, I also don’t pay much attention to its indications.

The only time when I pay very close attention to my Slow Stochastics is when it is “crossing the border” (or about to cross the border) from overbought/oversold into No Man’s Land. On the accompanying chart, these two regions are labeled “Action Area.” Usually, the borders are set at 80 and 20 in the Stochastics range. For me, Stochastics that are on the verge of leaving overbought/oversold territory represent a solid confirming signal of a potential turn. It is also the only time I will consider a swing trade, provided other criteria like support and resistance are also supporting the trade setup.

I hope that clarifies things a bit.

- James

James Chen is the Chief Technical Analyst at FX Solutions, a leading Forex broker. He is also a registered Commodity Trading Advisor (CTA) and a Chartered Market Technician (CMT) Level 3 candidate. At FX Solutions, Mr. Chen writes daily currency analysis, conducts forex trading seminars, and has authored numerous articles on currency trading and technical analysis for major financial publications. His upcoming book, Essentials of Foreign Exchange Trading (John Wiley & Sons), will be released in early 2009.