What is stochastic oscillator?
The Stochastic Oscillator is an indicator that compares the most recent closing price of a security with the highest and lowest prices over a given time period. It provides readings that move (oscillate) between zero and 100 to provide an indication of the security’s momentum.
Stochastic readings are essentially percentage expressions of a security’s trading range over a given period of time. (The default setting for the stochastic oscillator is 14 time periods: hourly, daily, etc.) A reading of 0 represents the lowest point of the trading range. A reading of 100 indicates the highest point during the designated time period.
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
- Low Low is the lowest low for the time period
- Maximum Maximum is the maximum maximum of the time period
History of oscillators
Dr. George Lane developed the stochastic oscillator in the late 1950s for use in technical stock analysis. Lane, a financial analyst, was one of the first researchers to publish research papers on the use of stochastics. He believed that the indicator could be used profitably in conjunction with Fibonacci retracement cycles or Elliott wave theory.
Lane noted that the stochastic oscillator indicates the momentum of a security’s price movement. It is not a price trend indicator like, for example, a moving average indicator is. The oscillator compares the position of a security’s closing price relative to the high and low (high and low) of its price range over a specified time period. In addition to measuring the strength of price movement, the oscillator can also be used to predict market reversal points.
Uses of the stochastic oscillator
The main uses of the stochastic oscillator are as follows:
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 breaks 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 returns 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.
divergence
Divergence occurs when the price of the security makes a new high or low that is not reflected in the stochastic oscillator. For example, the price moves to a new high, but the oscillator does not move accordingly to a new high reading. This is an example of a bearish divergence, which can indicate an imminent market reversal from an uptrend to a downtrend. Failure of the oscillator to make a new high throughout the price action indicates that the momentum of the uptrend is beginning 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 market reversal to the upside.
It is important to note that the stochastic oscillator can give a divergence signal some time before the price action changes direction. For example, when the oscillator gives a bearish divergence signal, the price may continue to rise for several trading sessions before turning to the downside. This is why Lane recommends waiting for some confirmation of a market reversal before entering a trading position. Trades should not be based on divergence alone.
crossings
Crossings refer to the point where 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 crosses the %D line and surpasses it, this is a bullish scenario. Conversely, the %K line crossing from above below the %D stochastic line gives a bearish sell signal.
Limitations of the stochastic oscillator
The main disadvantage of the oscillator is its tendency to generate false signals. They are especially common during turbulent and highly volatile trading conditions. This is why the importance of confirming Stochastic Oscillator trade signals with indications from other technical indicators is emphasized.
Traders should always keep in mind that the oscillator is primarily designed to measure the strength or weakness, not the trend or direction, of price action movement in a market.
Some traders aim to decrease the stochastic oscillator’s tendency to generate false trading signals by using more extreme readings of the oscillator to indicate overbought/oversold conditions in a market. Instead of using readings above 80 as a line of demarcation, they only interpret readings above 85 as indications of overbought conditions. On the bearish side, only readings of 15 and below are interpreted as signaling oversold conditions.
Although adjusting to 85/15 reduces the number of false signals, it can cause traders to miss some trading opportunities. For example, if during an uptrend the oscillator reaches a high reading of 82, after which the price turns back down, a trader may have missed an opportunity to sell at an ideal price point because the oscillator never reached its required overbought indication level of 85 or higher.
If you don’t like the standard Stochastic oscillatoryou can try the Advanced Stochastic Scalper:
A final word about the oscillator
The Stochastic Oscillator is a popular and widely used momentum indicator. Traders often use oscillator divergence signals to identify potential market reversal points. However, the oscillator is prone to generating spurious signals. Therefore, it is best used in conjunction with other technical indicators, rather than as a stand-alone source of trading signals.
