Stochastic Oscillator and how it works

Used as a tool to generate overbought and oversold trading signals, the Stochastic Oscillator typically tracks the speed and momentum of the market. Trading ranges of over 80 are considered in the overbought range and anything under 20 is considered oversold.

A Stochastic Oscillator is a momentum-based tool used by traders to compare the current closing price of a financial instrument over a period. 

The trading tool was developed by Dr. George Lane in the 1950s to be used in the technical analysis of securities. The reading in Stochastic Oscillator ranges between 0 to 100 where 0 is the lowest point and 100 indicates the highest point in the designated time.

The oscillator’s sensitivity to the market movements can be reduced by adjusting the time or taking a moving average of the result.

Used as a tool to generate overbought and oversold trading signals, the Stochastic Oscillator typically tracks the speed and momentum of the market. It does not consider price and volume. Further, it may also be used to predict market reversal points.

Trading ranges of over 80 are considered in the overbought range and anything under 20 is considered oversold. The charting of the Stochastic Oscillator consists of two lines – one representing the actual value of the oscillator in every session (%k) and the second reflecting its moving average over three days (%d). 

When the %k line remains above the %d line, it is seen as a bullish signal. Similarly, when the %k line crosses below the %d line, it is an indicator of a bearish trend. 

The intersection of these two lines is seen as a signal that a reversal may be coming up as it indicates a large shift in momentum from day to day.

However, it must be noted that the trading ranges in a Stochastic Oscillator may not always be indicative of a reversal. Strong trends in the overbought and oversold range can continue for an extended period. Hence, traders should be alert to changes in the stochastic oscillator for hints of a possible shift in the future trend.  The divergence between the stochastic oscillator and tending price action can be key indicators for a possible reversal.

Stochastic Oscillator Formula

The Stochastic Oscillator can be calculated using the following formula:

• %K for each day: 

%k = (Closing Price - Lowest Low) / (Highest High - Lowest Low) x 100

• 3-day Simple Moving Average of %k (%d):

%d = (Sum of %k of last 3 days)/3

Like every other trading tool, Stochastic Oscillator has its own set of limitations. It tends to generate false signals, especially during volatile trading conditions. Hence, traders need to confirm the trading signals generated by Stochastic Oscillators with indications from other technical indicators.

To counter the Stochastic Oscillator’s tendency to generate false signals, some traders use more extreme points in the range to indicate overbought or oversold conditions in a market.

Instead of using readings above 80 as a signal for an overbought trend, they consider readings above 85. Similarly, only readings of 15 or below are seen as signals of oversold conditions during a bearish run.

While the technique does reduce the chances of false signals, in some cases, it can also result in the trader missing trading opportunities.

Traders should use the Stochastic Oscillator along with other technical indicators to avoid false signals.