The stochastic oscillator is a very popular technical indicator that shows overbought and oversold levels. In this post, we will review the indicator, covering the following:
- What is the stochastic indicator?
- How the stochastic is calculated
- How to use the stochastic
- Trade examples
What is the stochastic indicator?
The stochastic indicator is a momentum oscillator that compares the most recent closing price to the highest and lowest prices over a specified period. That is, it indicates where the price is relative to its range over the specified period, and that is used to gauge the momentum of the price movement.
The indicator is usually plotted in the indicator pane under the price chart. It has two lines (%K or fast stochastic and %D or slow stochastic) that oscillate between 0 and 100 — a reading of 0 means the price is at the lowest point of the trading range, while a reading of 100 indicates the highest point of the range.
The stochastic indicator was created by George Lane in the late 1950s. The default setting is 14 periods, but it can be adjusted to any period of choice. However, adjusting the period setting can affect the sensitivity of the oscillator to price movements.
How the stochastic is calculated
George Lane calculated the stochastic using the formula below:
%K = [(C – L14)/(H14 – L14)] x 100
%K = The current value of the stochastic indicator
C = The most recent closing price
L14 = The lowest price during the 14 previous trading sessions
H14 = The highest price in the 14 previous trading sessions
Note that the %K refers to the fast stochastic indicator line. The “slow” stochastic indicator line is given as follows:
%D = 3-period simple moving average of %K
How to use the stochastic
The idea behind the indicator is that in an up-trending market trending, prices will close near the high, so the indicator would be rising. But in a down-trending market, prices close near the low, so the indicator would be declining.
Traders use readings of 80 and above to estimate overbought conditions in the market and 20 and below to estimate oversold conditions. Thus, when the %K line crosses above the %D line below a reading of 20 and then rises above 20, it is considered a buy signal, especially in an uptrend or a ranging market. When the opposite cross happens above 80 and the %K line descends below 80, it may be taken as a sell signal, especially in a downtrend or a range-bound market.
Another way to use the indicator is the divergence signal which occurs when the price action and indicator movements are out of phase. If the indicator makes a higher low when the price marks a lower low, there is a bullish divergence, which can be a good signal to go long (buy). If the indicator makes a lower high when the price shows a higher high, there is a bearish divergence, which may be a good signal to go short (sell).
The chart below shows a bullish divergence signal with a good entry point. The potential exit could be when the market became overbought.
The chart below shows a down-trending market. Note the downtrend line. After a small rally, the stochastic showed that the market was overbought, which was a good signal to go short or add to short positions. Notice the shooting star pattern rejected from the trend line.