A stochastic oscillator is a technical indicator that traders use to determine whether a given security is overbought or oversold. Traders will use a stochastic indicator, which is considered a momentum indicator, to compare a specific closing price of a security to a range of its prices over a certain time frame.
In other words, by using a stochastic chart traders can gauge the momentum of a security’s price with the aim of anticipating trends and reversals. A stochastic oscillator uses a range of 0 to 100 to determine if an asset is overbought (when the measurements are above 80) or oversold (when the measurement is below 20).
What Is a Stochastic Oscillator?
Let’s consider two main types of analysis that investors and traders commonly use when trading stocks: fundamental analysis and technical analysis.
Fundamental analysis incorporates earnings data, in addition to economic and market news, to predict how an asset’s price might move. Whereas technical analysis relies on various sets of data and indicators, such as price and volume, to identify patterns and trends.
The stochastic oscillator is a key tool in securities trading because it helps gauge how strong the momentum of the market is. Thus the stochastic oscillator, or sto indicator, is an indicator used in trading to assess trend strength.
History of the Stochastic Oscillator
Developed in the 1950s for commodities traders, the stochastic oscillator is now a common technical indicator that investors use to evaluate a variety of assets in many online investing platforms and price chart services.
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How Does a Stochastic Oscillator Work?
The stochastic oscillator has two moving lines, or stochastics, that oscillate between and around two horizontal lines. The primary “fast” moving line is called the %K and reflects with a specific formula, while the other “slow” line is a three-period moving average of the %K line.
The full stochastic oscillator is a line customized by the user that may combine the traits of the slow and fast stochastics.
Slow vs Fast Stochastics
A signal is generated when the “fast” %K line diverges above the “slow” line or vice versa. The two horizontal lines are often pre-set at 30 and 70, indicating oversold and overbought levels, respectively, but can be modified to other levels, such as 20 and 80, to reduce the risk of entering trades on false or premature signals.
The price is considered “overbought” when the two moving lines rise above the upper horizontal line and “oversold” when they fall below the lower horizontal line. The overbought line indicates price action that exceeds the top 20% (or 30%) of the recent price range over a defined period — typically 14-interval period. Conversely, the oversold line represents price levels that fit into the bottom 20% of the recent price range.
The stochastic oscillator is a form of stock technical analysis that calculates statistically opportune times for trade entries and exits. When both stochastics are above the ‘overbought’ line (typically 80) and the fast %K line crosses below the slow %D line, this may signify a time to exit a long position or initiate a short position.
Conversely, when both stochastics are below the oversold line (typically 20), and the %K line crosses above the %D line, this could signify a time to exit a short position or initiate a new long position.
The stochastic oscillator is especially useful among commonly day-traded assets such as low-float stocks that have limited amounts of shares and are more volatile.
However useful these stock indicators are for determining entry and exit points, most readers use them in connection with other tools. While a stochastic oscillator is useful for implementing an overall strategy, it does not assist with identifying the overall market sentiment or trend direction.
It is only when the trend or sideways trading range is well established that traders can safely and reliably use the stochastic oscillator to look for long entries in oversold conditions and shorts entries in overbought conditions.
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What Is the Formula for a Stochastic Oscillator?
Below is the calculation for a standard 14-period stochastic indicator, but the time period can be adjusted for any time frame.
Calculation for %K:
%K = [(C – L14) / H14 -L14)] x 100
Key:
C = Latest closing price
L14 = Lowest low over the period
H14 = Highest high over the period
%K is sometimes referred to as the “fast stochastic”, whereas the “slow” stochastic indicator is defined as %D = 3-period moving of %K.
The general idea for this oscillator is that in an uptrending market prices will close near the indicator’s high, and in a downtrending market prices will close near the low. Trade signals are generated when the “fast” %K line crosses above or below the three-period moving average, or “slow” %D.
The Slow %K Stochastic Oscillator incorporates a slower three-interval period that provides a moderate internal smoothing of %K. If the %K smoothing period was set to one instead of three, it would result in the equivalent of plotting the ‘fast stochastic.’
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Pros of the Stochastic Oscillator
There are several benefits to using the stochastic oscillator when evaluating investments.
Clear Entry/Exit Signals
The oscillator has a simple design and generates visual signals when it reaches an extreme level, which can help a trader determine when it’s time to buy or when to sell stocks.
Frequent Signals
For more active traders who trade on intraday charts such as the five, 10, or 15 minute time frames, the stochastic oscillator generates signals more often as price action oscillates in smaller ranges.
Easy to Understand
The oscillator’s fluctuating lines ranging from 0 to 100 are fairly clear for investors who know how to use them.
Available on Most Trading Platforms
The stochastic oscillator is a ubiquitous technical indicator found in many trading platforms, online brokerages, and technical chart services with similar configurations.
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Cons of the Stochastic Oscillator
Despite its benefits, the stochastic oscillator is not a perfect tool.
Possible False Signals
Everyone’s strategy is different but depending on the time settings chosen, traders may misperceive a sharp oscillation as a buy or sell signal, especially if it goes against the trend. This is more common during periods of market volatility.
Doesn’t Measure the Trend or Direction
The stochastic oscillator calculates the strength or weakness of price action in a market, not the overall trend or direction.
How to Trade With the Stochastic Oscillator
Some traders find the stochastic oscillator indicator useful to identify trade entry and exit points, and help decide whether they’re bullish on a stock. The stochastic oscillator does this by comparing a particular closing price based on the user’s selected time frame to a range of the security’s highest and lowest prices over a certain period of time.
Traders can reduce the sensitivity of the oscillator to market fluctuations by adjusting the time frame and range of prices. The oscillator tends to trend around a mean price level because it relies on recent price history, but it also adjusts (with lag) when prices break out of price ranges.
The Takeaway
The stochastic oscillator is a popular technical trading indicator, which can help investors find trading opportunities, measure movements, and calculate valuations. After identifying the direction of a security’s trend, the stochastic oscillator can help determine when the security is overbought or oversold, thus identifying lower-risk trade-entry points.
The oscillator uses a complex formula to calculate recent price averages according to the user’s preset time frame and the most recent price to the average price ranges. The tool plots the final calculation on a scale of 0 to 100, 0 being extremely oversold and 100 being extremely overbought. While technical indicators are not trading strategies on their own, they are useful tools when properly incorporated into an overall trading strategy.
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FAQ
Which is more accurate, RSI or Stochastic?
Relative strength index, or RSI, tends to be more useful for investors in trending markets, whereas Stochastics tend to be more helpful or reliable in non-trending markets.
What are the default indicator settings for Stochastic?
The default indicator settings for Stochastic Indicator are 5,3,3, though there are other commonly-used settings.
What is divergence in Stochastics?
Divergences are indications of a change, and can be used by traders or investors to try and determine whether a trend is getting weaker, stronger, or continuing.
Photo credit: iStock/alvarez
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