The stochastic oscillator

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The stochastic oscillator, also known as stochastic indicator, is a popular trading indicator​ that is useful for predicting trend reversals. It also focuses on price momentum and can be used to identify overbought and oversold levels in shares, indices, currencies and many other investment assets.

The stochastic oscillator measures the momentum of price movements. Momentum is the rate of acceleration in price movement. The idea behind the stochastic indicator is that the momentum of an instrument’s price will often change before the price movement of the instrument actually changes direction. As a result, the indicator can be used to predict trend reversals.

What is momentum? Before we get into using the Stochastic, we should be clear about what momentum actually is. Investopedia defines momentum as “The rate of acceleration of the price of a security.” The stochastic indicator analyses a price range over a specific time period or price candles; typical settings for the Stochastic are 5 or 14 periods/price candles. This means that the Stochastic indicator takes the absolute high and the absolute low of that period and compares it to the closing price.

Stochastic Oscillator Formula

The formula for calculating the Stochastic Oscillator is as follows:

%k = (Last Closing Price – Lowest Price)/(Highest Price – Lowest Price) x 100

%D = 3-day SMA of %K

Where:

C is the last closing price

Lowest Low is the lowest low for the time period

Highest High is the highest high for the time period

How does the stochastic indicator work?

The indicator works by focusing on the location of an instrument’s closing price in relation to the high-low range of the price over a set number of past periods. Typically, 14 previous periods are used. By comparing the closing price to previous price movements, the indicator attempts to predict price reversal points.

The stochastic indicator is a two-line indicator that can be applied to any chart. It fluctuates between 0 and 100. The indicator shows how the current price compares to the highest and lowest price levels over a predetermined past period. The previous period usually consists of 14 individual periods.

When the stochastic indicator is applied, a green line will appear below the chart. This green line is the %K line. There will also be a red line on the chart, which is the three-period moving average of %K. This is referred to as %D.

When the stochastic indicator is at a high level, it means the instrument’s price closed near the top of the 14-period range. When the indicator is at a low level, it signals the price closed near the bottom of the 14-period range.

The general rule for the stochastic indicator is that in an upward-trending​​ market, prices will close near the high. In contrast, in a downward-trending market, prices will close near the low. If the closing price slips away from the high or low, it signals that momentum​​ is slowing.

The stochastic indicator can be used to identify overbought and oversold readings. It can also predict trend reversals. There are a variety of strategies that traders use with the indicator.

How to read the stochastic indicator?

Stochastic oscillators display two lines: %K, and %D. The %K line compares the lowest low and the highest high of a given period to define a price range, then displays the last closing price as a percentage of this range. The %D line is a moving average of %K.

As with moving averages, when the two stochastic lines (%K and %D) cross, a signal is generated. If the green %K line crosses below the red %D line, a possible sell signal is generated. If the red %D line crosses below the green %K line, a possible buy signal is generated. These crossovers may appear anywhere on the study, but signals above the lines at 20 and 80 are considered to be stronger.

The stochastic indicator is scaled between 0 and 100.

  • A reading above 80 indicates that the instrument is trading near the top of its high-low range. A reading below 20 signals that the instrument is trading near the bottom of its high-low range.
  • Readings above 50 indicate the instrument is trading within the upper portion of the trading range. Readings below 50 signal that the instrument is trading in the lower portion of the trading range.
  • When the stochastic lines are above 80, the indicator signals that the instrument is overbought. When the stochastic lines are below 20, it signals that the instrument is oversold.
  • Overbought and oversold levels are useful for predicting trend reversals.
  • If the stochastic indicator falls from above 80 to below 50, it indicates that the price is moving lower. If the indicator moves from below 20 to above 50, it signals the price is moving higher.
  • Traders also look for divergence. This is when the trendline​​ of the stochastic and the trendline of the price move away from each other. This indicates that a price trend is weakening and may soon reverse.

Uses of the Stochastic Oscillator

  1. Identify overbought and oversold levels: An overbought level is indicated when the stochastic reading is above 80. Readings below 20 indicate oversold conditions in the market. A sell signal is generated when the oscillator reading goes above the 80 level and then returns to readings below 80. Conversely, a buy signal is indicated when the oscillator moves below 20 and then back above 20. Overbought and oversold levels mean that the security’s price is near the top or bottom, respectively, of its trading range for the specified time period.
  2. Divergence: Divergence occurs when the security price is making a new high or low that is not reflected on the Stochastic Oscillator. For example, price moves to a new high but the oscillator does not correspondingly move to a new high reading. This is an example of bearish divergence, which may signal an impending market reversal from an uptrend to a downtrend. The failure of the oscillator to reach a new high along price action doing so indicates that the momentum of the uptrend is starting to wane.

 

Similarly, a bullish divergence occurs when the market price makes a new low but the oscillator does not follow suit by moving to a new low reading. Bullish divergence indicates a possible upcoming market reversal to the upside.

 

It’s important to note that the Stochastic Oscillator may give a divergence signal some time before price action changes direction. For instance, when the oscillator gives a signal of bearish divergence, price may continue moving higher for several trading sessions before turning to the downside. This is the reason that Lane recommends waiting for some confirmation of a market reversal before entering a trading position. Trades should not be based on divergence alone.

 

  1. Crossovers: Crossovers refer to the point at which the fast stochastic line and the slow stochastic line intersect. The fast stochastic line is the 0%K line, and the slow stochastic line is the %D line. When the %K line intersects the %D line and goes above it, this is a bullish scenario. Conversely, the %K line crossing from above to below the %D stochastic line gives a bearish sell signal.

Limitations: The main shortcoming of the oscillator is its tendency to generate false signals. They are especially common during turbulent, highly volatile trading conditions. This is why the importance of confirming trading signals from the Stochastic Oscillator with indications from other technical indicators is stressed.

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