The Stochastic Oscillator is a technical indicator that moves back and forth between 0 and 100, providing a gauge of stock momentum. Developed by George C. Lane in the 1950s the main uses for the Stochastic Oscillator include divergences which can foreshadow reversals, overbought/oversold readings, bull/bear trade setups and crossovers which help pinpoint trade entries.
What Is the Stochastic Oscillator?
The Stochastic Oscillator is a two-line indicator that fluctuates between 0 and 100.
The indicator shows how the current price compares to the highest and lowest price over the look back period. Typically the look back is 14 periods; on a weekly chart that is 14 weeks, on an hourly chart 14 hours.
When the indicator is near zero it shows the price is trading near or below the lowest low during the look back period. If the indicator is near 100, the price is trading near or above the highest high during the look back period. Above 50 and the price is trading within the upper portion of the 14 period range; below 50 and the price is trading in the lower portion of the 14 period range.
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Stochastic Oscillator Calculation
Since the indicator has two lines-labelled %K and %D-there are two steps to calculating the Stochastic Oscillator values.
%K = (Current Close – Lowest Low) / (Highest High – Lowest Low) x 100
%D = 3-day SMA of %K
Lowest Low = lowest low for the look-back period (typically 14 periods)
Highest High = highest high for the look-back period (typically 14 periods)
SMA = Simple Moving Average
The above formula is for a “Fast Stochastic,” but there is also a “Slow Stochastic” version. It is the same as above except the Slow %K is averaged over 3 periods.
Slow %K = 3-period SMA of Fast %K
Slow %D = 3-period SMA of Slow %K
Since the Slow Stochastic is less choppy, many traders prefer it over the Fast Stochastic.
The Stochastic Oscillator is available on most trading platforms, such as ThinkorSwim, and on many free online charting sites, such as FreeStockCharts.com, StockCharts.com and Yahoo! Finance.
How It Is Useful
Uses for the Stochastic Oscillator include overbought/oversold readings, divergences. bull/bear trade setups and crossovers.
Overbought and Oversold
A security is overbought when the Stochastic is above 80, and the security is oversold if the indicator is below 20.
The labels are misleading though; overbought doesn’t necessarily mean the price will drop immediately, and oversold doesn’t mean the price will rally immediately. Overbought and oversold simply mean the price is trading near the top or bottom of the 14 day range, respectively. These conditions can last for a long time.
Traders do use overbought and oversold levels to monitor reversals though. If the indicator is overbought (above 80) and then falls below 50, it indicates the price is moving lower. If the price was oversold (below 20) and rallies above 50 it indicates the price is moving higher.
False or late signals occur frequently if these signals are traded unfiltered. Use the price trend to filter the signals.
During a price downtrend, enter short when the indicator was overbought and then drops below 50. During an uptrend, buy when the price was oversold then rallies above 50. The 50 level is commonly used, but can be adjusted based on personal trading strategies.
In Figure 2 this approach is applied to a stock trending higher. Only the long trades are initiated as the Stochastic moves above 50 after being oversold. Place a stop loss below the recent low that formed just before the signal (just above recent high for short sale signals).
Apply the same method to getting out of a profitable trade. Wait for the price to reach overbought levels (for long trades) then exit when the price falls below 50 (or 70 or 60 to get out a bit earlier). For short trades, let the price move to oversold levels, then exit when the price rallies above 50 (or 30 or 40 to get out a bit earlier).
Bearish divergence is when the price is making new highs, but the Stochastic isn’t. It shows that momentum has slowed, and a reversal could be forthcoming.
Bullish divergence is when the price is making new lows, but the Stochastic isn’t. It shows selling pressure has slowed, and a reversal higher could be around the corner.
Until divergence is confirmed by an actual turnaround in price, don’t base trades simply on divergence. A stock can continue to rise (or fall) for a long time even while bearish (or bullish) divergence is occurring.
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In April, Macy’s makes a higher high in price, but the Stochastic doesn’t, warning of a potential move lower.
In May, the price makes a lower low than it did in April, but the Stochastic makes a higher low, warning the move lower had lost momentum and an upside rally could ensue.
Bull and Bear Trade Setups
A bull trade setup is when the stochastic makes a higher high, but the price makes a lower high. The Stochastic is indicating that momentum is building and the price could rally following a pullback.
This is a setup that can be used with any number of entry signals. Here is one way to use it:
Once the bull setup has occurred the price will typically pullback and then rally, presenting a trade opportunity. Following the bull trade setup, buy after a pullback (the Stochastic must drop below 50 on the pullback) when the Stochastic rallies back above 50 (or 40 or 30).
A bear trade setup is when the stochastic makes a lower low, but the price makes a higher low. The Stochastic is indicating that selling pressure is building and the price could drop following a pullback higher.
In Figure 5, another type of entry signal is needed to enter a short position following the pullback higher. The Stochastic did not get back above 50, so it could drop back below, to provide the trade signal. The bear trade setup still provided warning about the forthcoming decline though.
In this case, the %K line (black) crossing back below the %D (red) following the bear trade setup provides a potential short entry. This crossover strategy can be used for the overbought and oversold strategy as well. For a downtrend the stop loss is placed above a recent high. For an uptrend signal the stop loss is placed below a recent low.
Stochastic Oscillator Limitations
The main drawback of the Stochastic is false signals. This is when an entry signal occurs on the indicator, but the price doesn’t follow through, resulting in a losing trade. During choppy market conditions this can happen frequently. One way to help with this is to use the trend as a filter—only take trade signals in the direction of the trend.
Bull and bear trade setups are prone to the same false signals, especially when the price lacks any clear direction. Trading in stocks with a clear direction and only taking trades in the same direction as that trend will help in this regard.
Divergence on the Stochastic is a warning signal, but isn’t a timing or trade signal. The price can continue to trend for a long time in the face of divergence. So while divergence works sometimes, it needs to be combined with other forms of analysis or a trade signal to make it an effective trading tool.
Proponents of the Stochastic Oscillator
The man attributed to devising the Stochastic Oscillator is George C. Lane (1921 – 2004). He was a trader, technical analyst, author, speaker and President of Investment Educators Inc. The Stochastic concept was based on the idea that momentum must always change before price.
The indicator is one of the most popular in use today, used by countless traders and included in many technical analysis newsletters. Despite the drawbacks highlighted, it continues to have a wide following mainly because of the numerous ways it can be used for both analyzing and trading all types of markets.
The Bottom Line
The Stochastic Oscillator is used in various capacities, including overbought/oversold levels, divergences and bull/bear trade setups. It can also be used to provide trade signals and let you quickly know where the price is in the context of the look back period. It moves between 0 and 100 and is prone to providing false signals. Using the indicator in conjunction with other indicators or price and trend analysis helps filter out some of the false signals.