Stochastic Oscillator is a momentum indicator that shows where the closing price is relative to a high and low range over a certain number of periods.
It was developed by George C. Lane in the late 1950s. He believed that momentum preceded price changes, so he created the Stochastic Oscillator to track the "speed" or momentum of price.
This oscillator works on the principle that in an uptrend the price will remain at or above the previous period’s closing price, while in a downtrend the price will remain at or below the previous period’s closing price.
In short:
- In an uptrend, prices tend to close near the highs.
- In a downtrend, prices tend to close near the lows.
If the closing prices start to slide down from the highs or lows, the momentum is considered to be slowing down.
The Stochastic indicator works best within wide trading ranges or slow-moving trends.
How Stochastic Works
The indicator range is from 0 to 100.
plots two lines, the moving average of the fast oscillation %K and %K, often called %D.
The Stochastic Oscillator measures the proximity of the high and low ranges relative to a given time period.
Assume that the highest price is equal to 100, the lowest price is equal to 90, , and the closing price is equal to 98.
This means that the high and low range is 10 (100-90), which is the denominator in the %K formula.
The closing price minus the lowest price equals 8, that is, numerator .
8 divided by 10 equals .80 or 80%.
Multiply this number by 100 to find %K.
If the closing price is 92 (.20 x 100), then
%K equals 20.
The Stochastic is above 50 when the close is in the upper half of the range and below 50 when the close is in the lower half of the range.
A low reading (below 20) means the price is close to its lowest price in a given time period.
High readings (above 80) indicate that the price is close to its highest point in a given time period.
How to Trade Stochastic
Overbought/oversold conditions
80 and 20 are the most commonly used levels. Generally speaking, an area above 80 is an overbought area, and an area below 20 is an oversold area.
- A sell signal is given when the
- oscillator is above 80 and then back below 80.
- oscillator falls below 20 and then moves back above 20.
A buy signal is issued when the
Cross signal
A crossover signal occurs when two lines cross in an overbought or oversold area.
- A sell signal occurs when the
- falling %K line of crosses the %D line in the overbought zone .
- rising %K line crosses the %D line in oversold territory.
A buy signal occurs when the
Divergence
Divergence forms when the price makes a new high or a new low but the Stochastic Oscillator does not.
- A Bullish Divergence forms when price forms lower lows but the Stochastic Oscillator forms higher lows. This indicates weakening downside momentum, signaling a potential bullish reversal.
- A Bearish Divergence forms when price forms higher highs but the Stochastic Oscillator forms lower highs. This signals weakening upward momentum and signals a potential bearish reversal.
There are three versions of the stochastic oscillator: fast , slow , and full.
Each version applies a different calculation to the value of the basic stochastic oscillator.
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