Stochastic Oscillator

Introduction

Within the realm of stocks, cryptocurrencies, bonds, and various securities, there is no shortage of indicators that you may use to discern any market condition you want.

Whether it is the RSI with its trend identification or ATR with its price volatility, you’ll find them freely available on many prominent exchanges, which you can use to your benefit. But the one indicator that we’ll be looking at here is the stochastic oscillator.

What is the Stochastic Oscillator?

Like the RSI, the stochastic oscillator happens to be a momentum indicator. George Lane was the man behind its creation way back during the late 1950s! But what does it actually do, or what is its purpose? Let’s find that out below.

The Purpose of the Stochastic Oscillator

The stochastic oscillator basically compares a certain closing price of the stock to a whole range of prices that it hits across a specific time period.

This oscillator’s sensitivity towards market movements can be reduced by changing the time periods or by acquiring a moving average, or MA, regarding the result.

It’s used to produce oversold and overbought trading signals, with its range of values being 0-100, which essentially indicates trend reversals or when the market is due for a significant change.

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How is the Stochastic Oscillator Calculated?

In this section, we’ll go over the formula used in calculating the stochastic oscillator, as well as the key parameters themselves and what they mean.

Formula for Stochastic Oscillator

So without further ado, here is the formula used in the calculation of the stochastic oscillator:

%K = (C-L14/H14-L14) x 100

%K Line (Fast Stochastic Line)

In the formula above, c represents the latest closing price, whereas L14 is the lowest price being traded during the 14 previous trading sessions.

H14 is basically the highest price within that same 14-day period, and %K would be the existing value of the stochastic oscillator.

%D Line (Slow Stochastic Line)

%D, which isn’t on the formula shown earlier, would be the 3-period MA of %K.

Key Parameters of the Stochastic Oscillator

Notably, that %K is sometimes referred to as a fast stochastic indicator, with the “slow” variant being %D.

The speeds of the stochastic oscillators refer to the settings utilized in the %K and %D inputs. The results acquired from applying the above formula would be the faster iteration.

But according to various traders, this may be a bit too reactive towards price changes, which might end up causing premature exits from positions.

The slow stochastic was made precisely to address this problem with its application of the three-period MA to the faster %K calculation.

But on the chart, you’ll likely see both the “slow” and “fast” lines; choose whichever you wish.

How to Use the Stochastic Oscillator in Trading

So, how does the stochastic oscillator apply in actual trading, or rather, how can it be interpreted? Let’s discover all of that below.

Overbought and Oversold Conditions

The stochastic oscillator, as we went over earlier, is range-bound in that it’s always between zero and 100, which can make it useful for determining oversold and overbought conditions.

Conventionally speaking, readings more than 80 are regarded as overbought indications, with readings under 20 signifying the opposite, i.e., oversold.

That said, these aren’t always indicative of an upcoming reversal. This is because extremely strong trends may maintain oversold and overbought conditions for extended periods of time.

Rather, traders should assess shifts within the stochastic oscillator in an attempt to discern clues regarding future trend shifts.

Stochastic Oscillator Crossovers

Stochastic oscillator charting typically comprises two lines, which we already noted earlier, with one representing the actual value pertaining to the oscillator for every session and the other reflecting its three-day SMA, short for simple moving average.

Since price is thought to echo momentum, an intersection of these lines is regarded as a signal for a reversal, which might be at play since it depicts a larger alteration in that day-to-day momentum.

This signal or crossover could either be bullish or bearish depending on which line crosses over one another.

Stochastic Divergence

Another important reversal signal would have to be the divergence between the trending price and the stochastic oscillator.

For instance, if a bearish trend hits a lower low when compared to the oscillator, which in turn displays a higher one, it could be implied that the bearish momentum is exhausting with a potential bullish reversal brewing.

Stochastic Oscillator Strategies for Different Trading Styles

Here, we’ll delve more into how the stochastic oscillator can relate to the trading styles that are most commonly used, namely, day, swing, and long-term trading.

Day Trading with Stochastic Oscillator

The default timeframe for the stochastic oscillator is 14 periods, with the three-period SMA for the slower line.

But really, it can be any period you want, so you can adjust it accordingly if you’re a day trader in that you can make them shorter. Once that’s done, you can then move on to gauging market sentiments through those overbought or oversold signals.

Swing Trading with Stochastic Oscillator

For swing traders, since their focus is more geared towards medium-to-long-term gains, the time frames that they’d prefer would perhaps be more medium.

And because they’re opening up some room for themselves to trade in by increasing the periods, they may benefit more from crossover strategies too.

Long-Term Investing with Stochastic Oscillator

As for those long-term traders, i.e., people who are in for the long haul, the time frames can be adjusted to reflect that too, or they could just rely on the slower line instead.

This is because it’s used to showcase the long-term trend of existing prices. In addition, this could further help them confirm whether to exit or enter a trade.

Advantages and Limitations of Stochastic Oscillator

Like with any indicator associated with the stock market, there will be some pros and some cons. Knowing both is integral to maintaining a good trading experience.

Benefits of Using the Stochastic Oscillator

Well, to start with the pros, it’s quite simple to get a hang of and can be alright for identifying trend reversals. Because of that, you can employ various strategies using this indicator, which should come in handy.

Limitations of the Stochastic Oscillator

Probably the most glaring limitation would have to be how it’s known to generate false signals.

This usually occurs when trading signals are produced with the prices not really following through, which could result in a bad trade.

Also, it’s a lagging indicator, which usually means that even if it is correct, it can take its time recognizing it. And lastly, momentum indicators like this aren’t that good in flat markets with little price action.

Conclusion

Imagine the stochastic oscillator as a bit of a warning signal, which tasks itself with identifying certain market conditions, specifically whether assets are oversold or overbought.

But it’s your job to ultimately decide whether or not the signals actually match the real market’s demand and supply conditions; false signals are obviously a thing.

Still, you can lower the likelihood of them popping by relying on other indicators alongside this one for additional confirmation. Overall, like the RSI, this can be a pretty useful indicator if utilized to its utmost potential.