Stochastic oscillator: A comprehensive guide

What is a stochastic oscillator?

Stochastic oscillator is a momentum indicator used in technical analysis, providing insights into market momentum and potential price reversals. Developed by George C. Lane in the 1950s, the stochastic oscillator has become a staple in the toolkit of technical analysts.

It compares an asset's closing price to its price range over a specified period, typically 14 days, to help traders identify potential buy and sell signals by analysing the relationship between current closing prices and historical price ranges.

The stochastic oscillator has gained popularity for generating oversold and overbought signals that can be applied to several trading strategies. It’s also relatively easy to use and understand for traders of all levels.

However, there’s a risk of false and delayed signals so traders should always use risk management strategies and several technical tools to protect their capital and optimise the outcome of their trades.

How does the stochastic indicator work?

The stochastic oscillator operates on the principle that in an uptrend, prices tend to close near their high, and in a downtrend, they close near their low. By calculating the relative position of the closing price within the high-low range, this indicator determines the momentum of the asset.

The indicator is composed of two primary lines: %K and %D. The %K line reflects the current closing price's position relative to the price range over a set period, while the %D line serves as a moving average of %K. These lines are instrumental in detecting momentum shifts and potential trading signals.

The stochastic indicator ranges from 0 to 100. A typical buy signal occurs when the %K line crosses above the %D line while both are below 20, indicating an oversold condition. Conversely, a sell signal is generated when the %K line crosses below the %D line above 80, suggesting an overbought condition.

Using the stochastic oscillator in trading

• Overbought and oversold conditions

One of the primary uses of the stochastic oscillator is to identify overbought and oversold levels. An asset is considered overbought when the indicator is above 80 and oversold when it’s below 20. These levels can help traders spot potential entry and exit points.

Overbought conditions: When stochastic readings exceed 80, it indicates that the asset's price may be overinflated. A drop below 80, especially if %K crosses below %D, signals a potential sell opportunity.

Oversold conditions: A reading below 20 suggests that the asset's price may have fallen too far. A rise above 20, with %K crossing above %D, could indicate a buying opportunity.

However, it's crucial to note that overbought and oversold signals can sometimes be misleading. An asset's price won't necessarily fall just because it’s considered overbought, nor will it automatically rise because it’s oversold. These signals simply indicate that the price is trading near the top or bottom of its recent range.

• Trend confirmation

The stochastic oscillator is also effective in confirming existing trends. In an uptrend, a bullish signal is observed when the %K line crosses above the %D line. Conversely, in a downtrend, a bearish signal is given when the %K line crosses below the %D line.

• Divergence trading

Divergence trading involves identifying potential trend reversals. A divergence occurs when momentum moves in one direction while price moves in the other direction.

Bullish divergence: This happens when an instrument’s price makes a new low, but the stochastic oscillator registers a higher low, signalling reduced selling pressure and a possible upward reversal.

Bearish divergence: This occurs when an instrument’s price makes a new high, but the stochastic oscillator shows a lower high, indicating waning upward momentum and a potential downward reversal.

It's important to wait for confirmation of a divergence through an actual price turnaround before making trading decisions, as prices can continue their trend for long periods. Therefore, the stochastic oscillator should be used together with other technical indicators to validate trading signals.