What is the Stochastic Oscillator?
The Stochastic Oscillator is an indicator that compares the most recent closing price of a security to the highest and lowest prices during a specific period of time. It moves back and forth between zero and 100 to provide an indication of the stock momentum. The stochastic oscillator is designed in a way that as the price increases, the closing price of the stock moves nearer to the maximum point during a specific period.
In addition, as the stock price declines, the closing price moves closer to the lowest point during a given period. The stock’s security is expressed as a percentage, such that 0% represents the lowest point while 100% indicates the highest point during the time period covered.
Stochastic Oscillator Formula
The formula for calculating Stochastic Oscillator is as follows:
%k = (Last Closing Price – Lowest Price)/(Highest Price – Lowest Price) x 100
%D = 3-day SMA of %K
- C is the last closing price
- Lowest Low is the lowest low for the time period
- Highest High is the highest high for the time period
Stochastic Oscillator History
Dr. George Lane developed the Stochastic Oscillator in the late 1950s for use in technical analysis of securities trading. Lane, a financial analyst, was one of the first researchers to publish research papers on the use of stochastic to forecast prices. He disclosed that the indicator could be used with the Fibonacci retracement, cycles, as well as Elliot Wave theory.
Lane noted that the Stochastic Oscillator follows the momentum of security prices and not the price or volume of anything similar. The oscillator compares the position of a security’s close-price compared to the high and low (max and min) price range during a specified period of time. It attempts to predict price turning points comparing security prices to the price ranges.
Uses of the Stochastic Oscillator
The following are some of the uses of stochastic oscillators:
1. Identify overbought and oversold levels
An overbought level is an area where the stochastic is above the 80 marks, while an oversold level is an area where the stochastic is below 20. A sell signal occurs when the oscillator goes beyond the 80th mark and then closes below 80. On the other hand, a buy signal is indicated when the oscillator is below 20 and closes back above 20. Overbought and oversold levels mean that the security prices are trading near the top of its high-low range or near the bottom of its high-low range.
Traders use the levels to monitor price reversals. For example, if the security’s price was above 80 and falls below 50, it indicates that the price is on a downward trend. When the price is below 20 and rises above 50, it is an indication that the security’s price is moving upwards.
Divergence occurs when the security price is making a new high or low that is not reflected on the Stochastic Oscillator. The divergence may be bullish which occurs when the security price makes a lower low, but the oscillator does not. It indicates that the selling pressure is slow, but a reversal could occur.
On the other hand, the divergence may be bearish, which occurs when the price makes new highs, but the Stochastic Oscillator does not produce a similar outcome. It indicates that the price momentum’s slowed and a reversal could occur. Before the divergence is confirmed by an actual rise or drop in price, trades should not be based on divergence alone.
Crossover refers to the point at which the fast stochastic line and the slow stochastic line intersect. The fast stochastic line (%K) moves at a faster rate than the slow stochastic line (%D), and under certain conditions, it can cross over the %D line.
When the K% line intersects the %D line and goes above the line, the scenario is interpreted to mean that the market is gaining at a faster rate than is indicated by the %D line. It indicates a buy signal. However, when the %K line moves below the %D stochastic line (because of a faster moving %K), it indicates a sell signal.
Limitations of the Stochastic Oscillator
One of the limitations of the oscillator is false signals. They are common during turbulent trading conditions when the indicator shows an entry signal but is not reflected in the price. Traders who follow such false signals may incur losses if they do not confirm the existence of simultaneous changes in the price. When such false signals occur, traders should only follow entry and exit signals that follow the direction of the price trends.
Also, reliance on divergence as a trade signal can be misleading to traders. When divergence shows a high or a low, the same trend is not reflected on the Stochastic Oscillator most of the time. Divergence should only be used when combined with other trade signals that are more accurate and less misleading.
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