The Stochastic Oscillator is a range-bound momentum indicator with a value that is always somewhere between 0 and 100. Stochastic is a term referring to the current price point in context of the price range of an asset over time.
Developed in the late 1950s by financial analyst Dr. George Lane, the technical indicator is used to generate overbought and oversold signals. It can be quite sensitive to even small market movements, though this sensitivity can be reduced by adjusting the time period it is used for or by taking a moving average of its results.
Stochastic Oscillators react more to momentum than to the absolute price of an asset and, according to Dr. Lane, momentum changes direction before price.
The formula for the Stochastic Oscillator is:
C = the most recent closing price
L14 = the lowest price traded of the 14 previous trading sessions
H14 = the highest price traded during the same 14-day period
%K = the current value of the stochastic indicator
%K is the value of the Stochastic Oscillator as calculated by the formula above. When shown on a graph, %K is plotted alongside another value referred to as %D. %D is the simple moving average of some value D (often 3) values of %K and is considered the signal or trigger line. Signal line crosses are used to determine changes in momentum. When the Stochastic Oscillator crosses above the signal line, it indicates the price is moving up and when it crosses below the signal line, the price may be moving downwards.
The theory behind the Stochastic Oscillator is that prices tend to close near the extremes of the recent range right before turning points, so traders use it to foreshadow reversals.
Due to being range-bound, the Stochastic Oscillator can also be used to identify overbought and oversold levels for an asset. As with other indicators that identify overbought and oversold levels, readings below 20 indicate the asset is oversold and readings above 80 indicate the asset is overbought.
An asset that is overbought is one analysts or traders consider to be trading above its intrinsic value. When an asset is overbought, the expectation is that it will correct itself and bounce back down in the near future. Analysts or traders consider oversold assets to be trading below their intrinsic value and expect the price of the asset to correct itself and bounce back up in the near future.
Stochastic Oscillators calculated based on a shorter look-back period will provide a choppy oscillator with many overbought and oversold readings. Stochastic Oscillators calculated based on longer historical periods produce a smoother oscillator with fewer overbought and oversold readings.
Divergences
Besides overbought and oversold levels, signals can also be read from the Stochastic Oscillator in the form of divergences.
When a price records a lower low but the Stochastic Oscillator forms a higher low, it is called a bullish divergence. Bullish divergence can signal less downward momentum and therefore foreshadow a bullish reversal, or the price rising in the future.
Traders seeking confirmation of a bullish divergence should look for either the Stochastic Oscillator breaking above 50 or the price breaking above a resistance level.
Bearish divergences follow similar rules: they happen if the price records a higher high but the Stochastic Oscillator forms a lower high, signaling slowing upward price momentum and a possible trend reversal.
To confirm a bearish divergence, look and see if the Stochastic Oscillator breaks below 50 or the price breaks below the support level.
Fast versus Slow
There are two main versions of the Stochastic Oscillator: fast and slow. The fast Stochastic Oscillator is the one explained above, where %K is calculated according to the original formula established by George Lane and %D is the (usually 3-day) SMA of %K.
The slow Stochastic Oscillator is more smooth. The slow %K is calculated by smoothing the fast %K with a 3-period SMA. The signal line of the slow Stochastic Oscillator, the slow %D, is the 3-period SMA of the slow %K.
The Stochastic Oscillator can be used to calculate all of these signals through Capitalise, the first automated trading platform allowing you to create strategies in plain English which Capitalise then monitors and executes for you. Better yet, Capitalise integrates with TradingView charts, allowing you to see the Stochastic Oscillator of a given asset in real time while making and running your strategy.
Here’s an example of how you enter and configure a trading strategy using the Stochastic Oscillator on the Capitalise platform:
When you type “Stochastic Oscillator” into the wizard, a dialog box that looks like this will pop up:
In the image above, the fillable fields are as follows:
Stoch_NumOfBars: the number of bars considered for the Stochastic Oscillator value, or %K
D: the number of %K values used to calculate %D
Smooth: the type of Stochastic Oscillator (fast or slow)
BarPeriod: the length of time each bar used to calculate the Stochastic Oscillator value stands for. It can range between 1 minute and 1 month although is typically set to 1 day.
Capitalise makes it easy and straightforward to set and follow the Stochastic Oscillator of your asset of choice to the specifications you require. Try it out and see how far you go when Capitalising on your ideas.
Please note that the examples provided here are purely for the purposes of illustrating how to use the Stochastic Oscillator and are not in any way to be taken as trading advice. This content is intended for information and educational purposes only and should not be considered investment advice or investment recommendation. Past performance is not an indication of future results. Read more here