The stochastic oscillator is a market momentum measure that compares a security's closing price with the range of its high to low prices over a certain time period to determine likely turning points in that asset's value.
It is, therefore, an indicator that shows overbought and oversold levels and is designed to provide traders with potential buy and sell signals depending on the price momentum rather than volume traded.
Stochastics was developed by George Lane (1921-2004), a securities trader and technical analyst with brokerage EF Hutton & Co, along with a group of other Chicago-based traders, in the 1950s.
The word "stochastic" is Greek for random but, as we'll learn, the stochastic indicator was designed to help take out the guesswork in trading.
Lane once described what the stochastic oscillator achieves using the following analogy: "If you visualise a rocket going up in the air - before it can turn down, it must first slow down. Momentum always changes direction before price."
Determining the oscillator
The theory suggests that in an upward-trending market, prices will close near the high, while in a downward-trending market prices close near the low point. Time periods for the stochastic oscillator can be minutes, hours, days, weeks or months, with day traders using the shorter periods.
If the closing price on any one day is compared with the range of daily highs and lows over the preceding 14 days, a measure of price momentum can be obtained.
The stochastic oscillator uses the following formula:
%K = 100(C-L14)/(H14-L14)
This is where:
- C is the most recent closing price
- L14 is the low price of the 14 previous trading days
- H14 is the highest price point of the same 14 trading sessions
- %K is the current market rate of the asset being traded
The stochastic oscillator is not complete without:
- %D, which is the indicator we follow most closely and is the three-day moving average of %K (or the average of the past three values of %K if %K is being measured in any time period other than days).
Modern trading platforms
If all of the above sounds a little laborious and time consuming, don't be concerned, as most modern trading platforms allow the trader to set various technical analysis charts alongside the main price chart, as in the example below.
This allows traders see multiple technical indicators to aid decision making when deciding upon which investments to pursue - and most experienced traders will advise to use several indicators to help confirm certain price signals.
Overbought and oversold
The oscillator is rangebound as the equation is essentially a percentile and can only sit between zero and 100.