Understanding the Stochastic Oscillator
The Stochastic Oscillator is a momentum indicator that assists traders in determining the best time to enter or exit a trade based on whether a financial instrument is overbought or oversold.
Dr. George Lane developed the concept of stochastics in the 1950s, which involves comparing the current price to a price range over a specific period of time.
The Stochastic Oscillator shows a stock’s closing price in relation to its high and low range over a 14-day period. According to Lane, the oscillator tracks the price’s momentum rather than being influenced by factors such as price or volume.
The graph of a stochastic oscillator typically consists of two lines, referred to as K and D:
- One line represents the oscillator’s actual value for each period.
- The other line reflects the three-day simple moving average.
When these two lines intersect, it indicates a potential reversal in momentum on a day-to-day basis.
Importance of the Stochastic Indicator
The stochastic indicator is utilized to assess market sentiment. It provides values between 0 and 100, with readings closer to 0 suggesting a bearish condition and readings closer to 100 indicating a bullish state. Unlike other indicators, the stochastic indicator does not display negative readings or values greater than 100.
Traders commonly use the thresholds of 20 and 80. Values below 20 suggest an oversold market, while values above 80 suggest an overbought market. However, extreme values above or below these thresholds do not always indicate a reversal.
Divergences occur when the Stochastic Oscillator fails to establish a new price high or low. A bullish divergence occurs when the price makes a lower low while the Stochastic Oscillator produces a higher low, indicating a decrease in negative momentum. Conversely, a bearish divergence occurs when the price makes a higher high while the Stochastic Oscillator makes a lower high.
Optimal Settings for the Stochastic Oscillator
The recommended settings for the Stochastic Oscillator are as follows:
- %K Length: 14
- %K Smoothing: 3
- %D Smoothing: 3
Calculating the Stochastic Oscillator
The Stochastic Oscillator can be calculated using the following formula:
H14 = Highest price during the last 14 periods
%K Slowing Period = The current value of the stochastic indicator3
C = Latest closing price
L14 = Lowest prices during the last 14 periods
Price momentum oscillators, such as the relative strength index (RSI), MACD, on-balance volume, aroon indicator, and the stochastic oscillator, are commonly used in technical analysis by traders and experts. While they are often used together, each indicator has its own underlying principles and techniques.
For example, the stochastic oscillator assumes that closing prices reflect the current market trend, while the RSI measures the speed of price changes to identify overbought and oversold levels. The RSI is generally more useful in growing markets, while stochastics are more helpful in sideways or turbulent markets.
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