The Stochastic Oscillator is an indicator that compares the most recent closing price of a security to the highest and lowest prices during a specified period of time. It gives readings that move (oscillate) between zero and 100 to provide an indication of the security’s momentum.
The stochastic readings are essentially percentage expressions of a security’s trading range over a given time period. (The default setting for the Stochastic Oscillator is 14 time periods – hourly, daily, etc.) A reading of 0 represents the lowest point of the trading range. A reading of 100 indicates the highest point during the designated time period.
Highest High is the highest high for the time period
Dr. George Lane developed the Stochastic Oscillator in the late 1950s for use in technical analysis of securities. Lane, a financial analyst, was one of the first researchers to publish research papers on the use of stochastics. He believed the indicator could be profitably used in conjunction with Fibonacci retracement cycles or with Elliot Wave theory.
Lane noted that the Stochastic Oscillator indicates the momentum of a security’s price movement. It is not a trend indicator for price as, for example, a moving average indicator is. The oscillator compares the position of a security’s closing price relative to the high and low (max and min) of its price range during a specified period of time. In addition to gauging the strength of price movement, the oscillator can also be used to predict market reversal turning points.
Uses of the Stochastic Oscillator
The following are the primary uses of the stochastic oscillator:
1. Identify overbought and oversold levels
An overbought level is indicated when the stochastic reading is above 80. Readings below 20 indicate oversold conditions in the market. A sell signal is generated when the oscillator reading goes above the 80 level and then returns to readings below 80. Conversely, a buy signal is indicated when the oscillator moves below 20 and then back above 20. Overbought and oversold levels mean that the security’s price is near the top or bottom, respectively, of its trading range for the specified time period.
Divergence occurs when the security price is making a new high or low that is not reflected on the Stochastic Oscillator. For example, price moves to a new high but the oscillator does not correspondingly move to a new high reading. This is an example of bearish divergence, which may signal an impending market reversal from an uptrend to a downtrend. The failure of the oscillator to reach a new high along price action doing so indicates that the momentum of the uptrend is starting to wane.
Similarly, a bullish divergence occurs when the market price makes a new low but the oscillator does not follow suit by moving to a new low reading. Bullish divergence indicates a possible upcoming market reversal to the upside.
It’s important to note that the Stochastic Oscillator may give a divergence signal some time before price action changes direction. For instance, when the oscillator gives a signal of bearish divergence, price may continue moving higher for several trading sessions before turning to the downside. This is the reason that Lane recommends waiting for some confirmation of a market reversal before entering a trading position. Trades should not be based on divergence alone.
Crossovers refer to the point at which the fast stochastic line and the slow stochastic line intersect. The fast stochastic line is the 0%K line, and the slow stochastic line is the %D line. When the %K line intersects the %D line and goes above it, this is a bullish scenario. Conversely, the %K line crossing from above to below the %D stochastic line gives a bearish sell signal.
Limitations of the Stochastic Oscillator
The main shortcoming of the oscillator is its tendency to generate false signals. They are especially common during turbulent, highly volatile trading conditions. This is why the importance of confirming trading signals from the Stochastic Oscillator with indications from other technical indicators is stressed.
Traders need to always keep in mind that the oscillator is primarily designed to measure the strength or weakness – not the trend or direction – of price action movement in a market.
Some traders aim to lessen the Stochastic Oscillator’s tendency to generate false trading signals by using more extreme readings of the oscillator to indicate overbought/oversold conditions in a market. Rather than using readings above 80 as the demarcation line, they instead only interpret readings above 85 as indicating overbought conditions. On the bearish side, only readings of 15 and below are interpreted as signaling oversold conditions.
While the adjustment to 85/15 does reduce the number of false signals, it may lead to traders missing some trading opportunities. For example, if during an uptrend, the oscillator reaches a high reading of 82, after which price turns to the downside, a trader may have missed the opportunity to sell at an ideal price point because the oscillator never reached their required overbought indication level of 85 or above.
A Final Word on the Oscillator
The Stochastic Oscillator is a popular, widely-used momentum indicator. Traders often use divergence signals from the oscillator to identify possible market reversal points. However, the oscillator is prone to generating false signals. Therefore, it is best used along with other technical indicators, rather than as a standalone source of trading signals.