A stochastic oscillator is a momentum indicator that shows the speed and dynamics of price movement. George C. Lane developed this indicator in the late 1950s. According to an interview with Lane, the stochastic oscillator “does not follow the price, does not follow the volume or anything like that. It follows the speed or momentum of the price. As a rule, the momentum changes direction earlier than the price.” Thus, bullish and bearish divergences on the Stochastic Oscillator can be used to predict reversals. This was the first and most important signal Lane identified. Lane also used this oscillator to determine bullish and bearish settings to anticipate a future reversal. Since the stochastic oscillator has a range orientation, it is also useful for determining overbought and oversold levels.
Understanding the Stochastic Oscillator
The stochastic oscillator is limited by a range, that is, it is always between 0 and 100. This makes it a useful indicator of overbought and oversold.
Traditionally, values above 80 are considered overbought, and values below 20 are considered oversold. However, these values do not always indicate an upcoming reversal: very strong trends can remain overbought or oversold for a long time. Instead, traders should pay attention to changes in the stochastic oscillator to get hints about future trend changes.
The stochastic oscillator chart usually consists of two lines: one reflecting the actual value of the oscillator for each session, and one reflecting its three-day simple moving average. Since it is believed that the price follows the momentum, the intersection of these two lines is a signal of a possible reversal, as it indicates a significant change in momentum from day to day.
The discrepancy between the stochastic oscillator and the trending price movement is also considered as an important reversal signal. For example, when a bearish trend reaches a new lower low and the oscillator shows a higher low, this may be a sign that the bears have exhausted their momentum and a bullish reversal is brewing.
How Does Stochastic Oscillator Work?
The indicator measures the recent closing of the price in relation to the highest and lowest point of the range in which the security was traded during a certain number of past periods. The standard number of periods used for measurement is 14. For example, on the daily chart it will be 14 days. On the hourly chart – 14 hours, etc.
A stochastic indicator is a two-line indicator that traders can use on any chart. These two lines are the %K and %D lines, which move in the range from 0 to 100.
- When the stochastic indicator is at a high level, the price of the instrument closes near the upper limit of the 14-period range.
- On the contrary, when the indicator value is low, the price closes near the lower limit of the 14-period range.
- The general rule for a stochastic indicator is that in an uptrend market, prices will close near the maximum. Conversely, in a market with a downtrend, prices close near the minimum. If the closing price moves away from the high in the bull market or from the low in the bear market, then the momentum is slowing down, and a reversal may soon begin.
Example of the Stochastic Oscillator
Stochastic oscillators are a part of most graphical tools and can be easily used in practice. The standard time period is 14 days, but it can be changed according to specific analytical needs. The stochastic oscillator is calculated by subtracting the minimum for the period from the current closing price, dividing by the total range for the period and multiplying by 100.
As a hypothetical example, if the 14-day high is $150, the minimum is $125, and the current close is $145, then the readings for the current session will be: (145-125) / (150 – 125) * 100, or 80.
Comparing the current price with a time range, the stochastic oscillator reflects the sequence with which the price closes near a recent high or low. A reading of 80 indicates that the asset is on the verge of being overbought.
Reading Stochastic Indicator
As we said above, the stochastic oscillator moves in the range from 0 to 100. However, the price usually does not reach these extremes. Therefore, traders usually use levels 20 and 80 as markers for overbought and oversold zones.
If the indicator rises above 80, then the instrument is trading near the upper limit of its high low range and is currently overbought. Conversely, if the indicator falls below 20, then the instrument is trading near the lower limit of its range of high and low values and is currently in an oversold state. Usually, when the price reaches the overbought and oversold zones, it means that a reversal will occur soon.
If the oscillator rises above 50, then the instrument is trading in the upper part of the trading range, and the market is dominated by “bulls”. On the contrary, if the oscillator moves below 50, then the instrument is trading in the lower part of the trading range, and the market is dominated by “bears”.
Overbought and oversold levels are useful for predicting trend reversals.
Limitations of the Stochastic Oscillator
The main disadvantage of the oscillator is its tendency to form false signals. They occur especially often in conditions of turbulent, highly volatile trade. That is why it is important to confirm trading signals from the Stochastic Oscillator with the readings of other technical indicators.
Traders should always remember that the oscillator is primarily designed to measure strength or weakness, and not the trend or direction of price movement in the market.
Some traders seek to reduce the tendency of the Stochastic Oscillator to generate false trading signals by using more extreme oscillator readings to indicate overbought/oversold conditions in the market. Instead of using readings above 80 as a demarcation line, they interpret readings above 85 as evidence of overbought. On the bearish side, only readings of 15 and below are interpreted as an oversold signal.
Although the 85/15 correction reduces the number of false signals, it can lead to traders missing out on some trading opportunities. For example, if during an uptrend the oscillator reaches a maximum of 82, after which the price turns down, the trader may miss the opportunity to sell at the ideal price, since the oscillator has not reached the required overbought level of 85 or higher.
How to read a Stochastic Oscillator?
The stochastic oscillator represents the latest prices on a scale from 0 to 100, where 0 is the lower bound of the recent time period, and 100 is the upper bound. Readings of the stochastic indicator above 80 indicate that the asset is trading near the upper limit of its range, and readings below 20 indicate that it is near the lower limit of its range.
What does %K mean on a Stochastic Oscillator?
On the stochastic oscillator chart, %K represents the current price of a security, expressed as a percentage of the difference between its highest and lowest values for a certain period of time. In other words, K represents the current price relative to the recent price range of the asset.
What is %D on a Stochastic Oscillator?
On the stochastic oscillator graph, %D represents the average value of %K over 3 periods. This line is used to display the long-term trend of current prices and indicates that the current price trend persists for a long period of time.
Stochastic Oscillator is a powerful tool for traders that helps identify potential market reversals and momentum changes. You can gain an advantage in the market if you understand how it works and how to use it in your trading strategy. However, it is important to remember that no technical indicator is trouble-free, so it is always important to manage risks and trade in a disciplined manner.