A stochastic oscillator is a momentum indicator that compares a particular closing price of a security to a range of its prices over a specific period. By adjusting the time period or incorporating a moving average of its results, this indicator’s sensitivity to market movements can be tailored. The oscillator is notably used to generate overbought and oversold trading signals within a bounded range of 0 to 100.
Key Takeaways
- A stochastic oscillator is a highly regarded technical indicator for signaling overbought and oversold market conditions.
- Initially developed in the 1950s, it maintains popularity as a momentum indicator.
- The oscillator fluctuates within a range of values due to being based on historical prices.
- It assesses the momentum of an asset’s price to determine trends and predict potential reversals.
- Values above 80 suggest the asset is overbought, while values below 20 indicate it’s oversold.
Understanding the Stochastic Oscillator
The stochastic oscillator is always confined between 0 and 100, proving to be an excellent gauge for overbought and oversold scenarios.
Typically, readings over 80 imply overbought conditions, whereas readings below 20 indicate oversold conditions. Nevertheless, these parameters don’t always signal immediate reversals since strong trends can persist in these ranges. Instead, traders should monitor changes in the stochastic oscillator to foresee potential trend shifts.
Stochastic oscillator charts generally feature two lines: one for the actual oscillator value per session and another for its three-day simple moving average. The convergence of these two lines signals a potential momentum shift, hinting at an impending reversal.
Divergence between the oscillator and the price trend is another critical reversal signal. For example, if a downward trend hits a new low while the oscillator forms a higher low, it could indicate a weakening bearish momentum, hinting at a possible bullish reversal.
Formula for the Stochastic Oscillator
The stochastic oscillator formula is represented by:
%K = (C - L14) / (H14 - L14) * 100
Where:
- C = Most recent closing price
- L14 = Lowest price over the last 14 sessions
- H14 = Highest price over the same 14-day period
%K measures the progressive value of the indicator in question. The ‘slow’ stochastic adopts %D, a 3-period moving average of %K. To enhance smoother curves, slow %K incorporates an internal smoothing period, often set to adjust volatile fast stochastics.
History of the Stochastic Oscillator
Developed by George Lane in the late 1950s, the stochastic oscillator highlights the position of a stock’s closing price relative to its high and low over a set period, generally 14 days.
Lane emphasized that the oscillator is not driven by price or volume but by the speed or momentum of price changes. He noted that momentum shifts precede price direction changes, allowing the oscillator to forecast reversals via bullish or bearish divergences.
Practical Example of the Stochastic Oscillator
In practice, the stochastic oscillator is a staple in charting tools. While the standard period is 14 days, adjustments can be tailored for specific analysis needs. Here’s a hypothetical example:
- 14-day high: $150
- 14-day low: $125
- Current close: $145
Using the formula:
(145 - 125) / (150 - 125) * 100 = 80
A reading of 80 signifies approaching overbought conditions as the price closes higher in its range.
Relative Strength Index (RSI) vs. Stochastic Oscillator
The Relative Strength Index (RSI) and stochastic oscillator are both pivotal in technical analysis, providing momentum-based data. The RSI measures purchase velocity, quantifying overbought and oversold levels, whereas the stochastic oscillator is optimal in consistent trading ranges.
Generally, the RSI is prized for trending markets, while stochastic indicators excel in sideways ranges.
Limitations of the Stochastic Oscillator
The primary drawback of the stochastic oscillator lies in its susceptibility to false signals, especially in highly volatile markets. Leveraging the price trend as a filter mitigates this, taking trades that align with the prevailing trend.
How to Read the Stochastic Oscillator
The stochastic oscillator scales recent prices from 0 to 100: scores above 80 indicate trading near the upper limit of its range, whereas scores below 20 suggest the opposite.
What Does %K Represent on the Stochastic Oscillator?
On a chart, %K signifies the current price as a percentile within the asset’s latest historical range.
What Does %D Represent on the Stochastic Oscillator?
%D embodies the 3-period moving average of %K, showcasing the sustained price movement trend.
Related Terms: Relative Strength Index (RSI), moving average, price momentum, technical indicators, trading signals.
References
- Fidelity. “Slow Stochastic”.
- George Pruitt. The Ultimate Algorithmic Trading System Toolbox + Website: Using Today’s Technology To Help You Become A Better Trader. John Wiley & Sons, 2016.
- CMC Markets. “What Is the Stochastic Indicator?”
