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.
Traditional settings - which are indicated on Capital.com's stochastic oscillator analysis - consider that when %D (the red dotted line) falls below 20 it is entering oversold territory, can indicate a buy signal. Conversely, when the oscillator moves above 80, this is considered to be the overbought threshold and can indicate a sell signal.
During a price downtrend, traders often enter short when the indicator was overbought and then drops below 50. During an uptrend, they buy when the price is oversold then rallies above 50. The 50 level is commonly used, but can be adjusted based on personal trading strategies.
Consider the chart:
The oscillator correctly identifies a number of opportunities, both on the buy and sell side, for investors to trade the euro versus the dollar profitably, as indicated by the black ovals.
Shorter period timeframes than days are also useful for calculating the stochastics oscillator.
The chart above shows each daily trading session broken up into eight periods of three hours. Although the oscillator is a little more jagged, the buy and sell signals are clearly still there - an obvious benefit for the day trader, who will be in and out of the market during a single trading session.
Some, however, can be a little misleading - the strong upward spike on 2 April, for example, came during a six- or seven-day period of broadly inactive price movement.
Trading on divergence
Bearish divergence is when the price hits new highs, but the Stochastic doesn't. That is generally read to mean that momentum is slowing and a reversal could be forthcoming. On the other hand, bullish divergence is when the price is tumbling to new lows but the Stochastic doesn't follow. This suggests selling pressure has slowed and a reversal is nigh.
But traders are generally warned not to make a trade until divergence is confirmed by an actual price change.
The bottom line
Stochastic oscillator strategy can work well. The evidence is in the chart. But the labels cab be misleading. Overbought won't guarantee the price will drop, and oversold won't guarantee a price rally. Day traders need to be aware that these conditions can remain in place for a long time.
False or late signals occur frequently if these signals are traded unfiltered. As with most trading tools, it is nest to use in conjunction with others to confirm price movements.
But stochastic trading has been around for a long time and has won many adherents. "Since the oscillator is over 50 years old, it has stood the test of time, which is a large reason why many traders use it to this day," says Jeremy Wagner, head of forex trading at DailyFX.
But like all technical analysis, it is not infallible. This is why several technical analysis strategies should be used in conjunction to give the trader the best chance of hitting profit.