The stochastic oscillator is a momentum indicator that compares a security’s closing price to a range of the security’s prices across time. By adjusting the time period or using a moving average of the result, the oscillator’s susceptibility to market changes can be reduced. It uses a 0–100 defined range of values to generate overbought and oversold trading signals.
TAKEAWAYS IMPORTANT
• A stochastic oscillator is a prominent momentum indicator that was first established in the 1950s and is used to generate overbought and oversold indications.
• Because stochastic oscillators are based on an asset’s price history, they tend to fluctuate around a mean price level.
The Stochastic Oscillator’s Formula
The fast stochastic indicator is frequently referred to as % K. The “slow” stochastic indicator is calculated as % D = %K 3-period moving average. Prices close near the high in a market heading upward, and prices close near the low in a market trending downward, according to the broad idea that underpins this indication. When the %K crosses through the %D, a three-period moving average, transaction signals are generated.
The Slow % K integrates a % K slowing period of 3 that governs the internal smoothing of % K, which is the difference between the slow and fast Stochastic Oscillators. Plotting the Fast Stochastic Oscillator is comparable to setting the smoothing period to 1.
What Can You Learn From the Stochastic Oscillator?
The stochastic oscillator is range-bound, which means it always oscillates between zero and one hundred. As a result, it can be used to spot overbought and oversold conditions. Values over 80 are traditionally regarded overbought, while readings under 20 are considered oversold. However, these are not always indications of an oncoming reversal; very strong trends can persist for a long time in overbought or oversold levels. Traders could instead search for hints regarding future trend shifts in the stochastic oscillator. A stochastic oscillator’s chart normally includes two lines: one that shows the oscillator’s current value for each session, and the other that shows its three-day simple moving average.
Because price is meant to follow momentum, the intersection of these two lines is interpreted as a hint of impending reversal, as it indicates a major change in momentum from day to day. Divergence between stochastic oscillator and the trending price action is often seen as a critical reversal signal. When a bearish trend achieves a new lower low but the oscillator prints a higher low, it may imply that the bears are losing momentum and a bullish reversal is approaching.
A Quick Overview of History
George Lane created the stochastic oscillator with in late 1950s. The stochastic oscillator, as designed by Lane, displays the location of a stock’s closing price in relation to its high and low range over a period of time, often a 14-day period. Lane has stated multiple times in interviews that the stochastic oscillator does not follow price, volume, or anything else. He believes that the oscillator monitors the price’s speed or momentum.
In interviews, Lane also indicates that, on average, the momentum or speed of a stock’s price changes before the price changes. 2 When the stochastic oscillator shows bullish or bearish divergences, the indicator can be utilized to predict reversals. Lane regarded this indication as the earliest and, probably, the most important trading signal.
How to Use the Stochastic Oscillator in Reality
Most charting software includes a stochastic oscillator, which is simple to use in practice. The normal time duration is 14 days, although this can be changed to fulfill specific analytical requirements. Subtract the period’s low from the current closing price, divide by the period’s total range, then multiply by 100 to get the stochastic oscillator.
For instance, if the 14-day high is $150, the low is $125, and the current close is $145, the current session reading would be (145-125) / (150 – 125) * 100, or 80. The stochastic oscillator measures how consistently the price closes near its recent high or low by comparing the current price to the range over time. A reading of 80 indicates that the asset is heading overbought territory.
The Relative Strength Index (RSI) vs. the Stochastic Oscillator
Price momentum oscillators such as the relative strength index (RSI) and the stochastic oscillator are widely used in technical analysis. Despite the fact that they are frequently employed together, they each have independent underlying ideas and methodologies. The stochastic oscillator is based on the idea that closing prices should be close to the current trend.
Meanwhile, the RSI measures the velocity of price fluctuations to detect overbought and oversold levels. To put it differently, the RSI was created to track the rapidity of market fluctuations, but the stochastic oscillator formula excels in trading ranges that are consistent. The RSI is generally more beneficial in trending markets, whereas stochastic are more useful in sideways or turbulent markets.
The Stochastic Oscillator’s Limitations
The stochastic oscillator’s main flaw is that it has been known to produce false indications. This occurs when the indicator generates a trading signal but the price does not follow through, resulting in a loss trade. This might happen on a frequent basis during volatile market conditions. Using the price trend as a filter, where signals are only taken if they are in the same direction as the trend, is one technique to aid with this.
Conclusion
The stochastic oscillator is a momentum indicator that compares the closing price of a security to a range of its prices across time. The indicator can also be used to spot turns near resistance or support. The Stochastic Oscillator’s settings are determined by personal preferences, trading style, and timeframe. A choppy oscillator with many overbought and oversold values will result from a shorter look-back period. With a longer look-back period, the oscillator will be smoother, with fewer overbought and oversold values.
The Stochastic Oscillator, like all technical indicators, should be used in conjunction with other technical analysis tools. Volume, support/resistance, and breakouts can all be utilized to validate or disprove Stochastic Oscillator indications.