STOCHASTIC OSCILLATOR

What is a Stochastic Oscillator?

The stochastic oscillator shows a comparison between the closing price of a stock and a series of prices of that same stock over time. It is an indicator that tends to oscillate around the average price level. The reason for this is a whole range of stock prices that affect it. Traders use it to determine signals that indicate overbought and oversold positions. Its characteristic is a high level of prediction of whether it is time to buy or sell, and has high accuracy. All this makes it one of the most popular momentum indicators. It uses a range of values from 0 to 100. 

The formula for the Stochastic Oscillator looks like this:

%K = [(C – L14) / (H14 – L14)] x 100

C – The most recent closing price.

L14 – The lowest price traded of the 14 previous trading periods

H14 – The highest price traded during the same 14 periods

%K – The current value of the stochastic indicator

The number 14 in the formula represents 14 periods. Depending on the objectives of the technical analysis, this period can be daily, weekly, monthly.

stochastic oscillator

Slow and Fast 

The stochastic oscillator lies in the theory that prices will close near to high if the trend is upward. Conversely, the price closes near to low in the downward market trend. When the price closes at a high or low end, it tends to trade at that end of price action or price range. The% K indicator can also be called slow. When% K passes through the three-period moving average, then it is fast, and its label is then% D. Passing% K through a three-period moving average creates signals for the transaction. 

The formula for %D looks like this:

%D = (H3 / L3) x 100

H3 – Highest of the three previous trading periods

L3 – Lowest price traded during the same three-period

The trend of price movements that is relevant for the calculation of these formulas is price action. 

How to read a chart?

When observing the graph, you can notice the K line moves faster than the D line. The investor watches the lines move. In doing so, one should observe how the price and the D line move and monitor their changes. In other words, whether they move into overbought or oversold zones. If they are moving in the overbought zone (above 80), the trader should consider selling. If they are moving in the oversold zone (a level below 20), he should consider buying.

The Stochastic Oscillator image 1

One such example is in this chart. For example, you can see a strong signal to buy in early April. It is a favorable period of, say, 12 days in the price range from the middle $ 30 area to the middle $ 50 area. You can see short periods favorable for sale, also.

What is Price Action?

Price action is the range of market prices at which a stock is traded over a period, usually daily. 

The price range traded may be above the closing price or below the closing price. For example, if the opening stock price was $ 20 and the price range during trading moved from the lowest daily $ 18 to the highest daily $ 23.5. Then the price action would be between $18 and $ 23.5. It doesn’t matter if the closing price was $ 22.5. The same way is just the opposite in case the share price moved downwards. The closing price tends to be near to or at the lowest range of daily trading. 

Why is the Stochastic Oscillator useful?

As said, the oscillator ranges between the values 0 and 100. Thus it indicates the areas overbought and oversold. When over 80 is overbought, and beneath 20 is oversold. When these trends are strong, then they tend to stay that way for an extended period. In such a situation, there is no insight into whether and when there will be a reversal. Therefore, the changes observed in the oscillator are useful for indications about impending changes. 

The chart of usefulness

After recording the necessary price changes and their tendencies during the relevant period, the technician draws the lines on the chart. There is one line on the graph that represents the actual value of the stochastic oscillator for each period. There is another line that reflects the three-period (day) simple moving average. The intersection of these two lines is more likely a sign that a reversal may be in progress. It is because such a cross-section indicates a massive shift in momentum from period to period, and the price is likely to follow it.

The Stochastic Oscillator image 2

Divergence as a signal for reversal

Price movements relative to the stochastic oscillator, during the trend, also speak. When a price moves, so its divergence occurs concerning the oscillator, it can be a relevant signal for a reversal. 

For example, the bearish trend is ongoing, and prices are reaching a new lower low. However, when the oscillator records a new higher low, it is probably a sign that the bearish momentum is on the exhale. It heralds a reversal and the bullish momentum is about to happen.

How To Use The Stochastic Oscillator?

As already stated,  you can calculate it using a formula. Traditionally, a period of 14 days is authoritative. You can always adjust that period according to the needs of the analysis. Namely, from the current closing price recorded most recently, the lowest price traded during the given period is deducted. Then that value is divided by the total price range for that same period. The price range is equal to the difference between the highest and lowest price. Then all that is multiplied by 100. 

Example 

If we show it in numbers, the example looks like this. Say, the highest price over 14 days was $ 200, and the lowest at $ 150. Currently, the closing price is $ 190. Then it would be:

[(190 – 150) / (200 – 150)] x 100 = 80

It reflects the consistency of how much the closing price is near to its recent high or low. The value from the previous example of stochastic oscillator calculation shows that it is on the overbought limit. 

Stochastic oscillator in combination with other indicators

In technical analyses, this indicator can be used in combination with other indicators, too. One of them and one of the also more popular is the Relative Strength Index. Each of them has a different approach and method. The stochastic oscillator predicts that the price will close where the current trend is, or at least close to it. RSI uses price velocity measurements to track overbought and oversold levels. So the difference between these two indicators is that the RSI monitors the speed of price movements while the Stochastic Oscillator predicts where the price will close. In other words, the oscillator is a good fit for consistent ranges, where the price follows the trend. 

When can it go wrong?

One of the disadvantages of this oscillator is the possibility of false signals. It is the case when the share price does not follow the movement of the indicator. More precisely, the indicator gives a different signal from the price movement. It can especially happen during unstable market conditions. The way to overcome this is to take into account the price trend. It is then a confirmation of the signal given by the indicator, in other words, when the price trend is aligned and in the same direction as the signals.

Good job, you’ve made another important step to become a knowledgeable trader. How about you continue your journey through the next recommended term Moving Average?