The Stochastic Oscillator is a simple momentum indicator that is often used by traders to help determine whether an asset is currently "overbought" or "oversold" as well as to predict potential price trend reversals.
Created by George C. Lane in the late 1950s, the design of the Stochastic Oscillator is based around the idea that that prices tend to close near the extremes of the recent range before turning around.
The %K and %D Components
There are 2 primary components to the Stochastic Oscillator indicator - the %K line and the %D line.
These two values are calculated based on the following formula:
%K = 100 × (C − L14) / (H14 − L14). If H14 equals L14, this expression is undefined.
Where:
C = Latest Closing price
L14 = Lowest low for the past 14 periods
H14 = Highest high for the past 14 periods
%D = 3-Period Simple Moving Average of %K
Visual representation of the stochastic oscillator
On a chart, the Stochastic Oscillator is displayed as a two wavy lines known as the %K line and the %D line respectively in a separate section below the asset price chart.
The %D line is simply a smoothed-out less choppy version of the %K line and is often known as the Signal line.
Buy & Sell Signals
There are 3 common methods in which the Stochastic Oscillator can be used as a tool to determine when it is a good time to enter or exit the market. They are the overbought/oversold levels, the crossover signals and the divergence patterns.
Overbought & Oversold Levels
The Stochastic Oscillator, and this includes both the %K and the %D values oscillate between 0 and 100.
Readings below 20 or above 80 are commonly called oversold or overbought. These describe the close relative to a recent trading range, not fundamental cheapness or expensiveness. A strong trend can persist despite an extreme reading; the indicator alone is not a trade recommendation.
Readings below 20 or above 80 are commonly called oversold or overbought. These describe the close relative to a recent trading range, not fundamental cheapness or expensiveness. A strong trend can persist despite an extreme reading; the indicator alone is not a trade recommendation.
Crossover Signals
When the %K line cross above the %D line, it is a bullish crossover signal that indicates a buying opportunity.
On the other hand, a bearish crossover occurs when the %K line cross below the %D line. When this happens, it indicates that prices may go down and it may be a good time to sell.
Divergence Strategy
Another strategy often employed by traders using the Stochastics Oscillator to find trading opportunities is the Stochastic Divergence strategy.
Bearish Divergence
Bearish divergence is when the asset price is making higher highs, but the Stochastic is not. This shows that momentum has slowed, and that a reversal could be imminent.
Bullish Divergence
Bullish divergence is when the asset price is making new lows, but the Stochastic indicator is not. It shows selling pressure has slowed, and a reversal higher could be forthcoming.
However, until divergence is confirmed by an actual turnaround in price, do not place your trades purely on divergence. The asset price can go on to rise (or fall) for a long time even while bearish (or bullish) divergence is ongoing.
