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The stochastic oscillator is a momentum indicator that traders use to compare a specific closing price of a security to a range of its prices over a defined period, usually 14 days.
Traders typically use a stochastic oscillator to determine whether a given security is overbought or oversold, in order to anticipate reversals. A stochastic oscillator uses a range of 0 to 100. When levels are above 80, it may indicate an asset is overbought; when the indicator is below 20, it may be oversold. When the price rises above or below those levels, a reversal may be in store.
To avoid the possibility of false signals, traders often use the sto indicator with another type of trend analysis.
Key Points
• The stochastic oscillator is a momentum indicator that’s used to anticipate reversals by determining if a security is overbought or oversold.
• The indicator is range-bound from 0 to 100, with levels above 80 typically indicating an overbought asset and levels below 20 suggesting an oversold asset.
• The oscillator consists of a “fast” line (%K, representing current price) and a “slow” line (%D, a three-period moving average of %K).
• Trade signals are generated when the fast %K line crosses above or below the slow %D line, especially when both are in the overbought or oversold regions.
• While the oscillator provides clear entry and exit signals, it should be used with other trend analysis to mitigate the risk of false signals.
What Is a Stochastic Oscillator?
Let’s consider two main types of analysis that investors and traders commonly use when trading stocks: fundamental analysis and technical analysis.
• Fundamental analysis incorporates earnings data, in addition to economic and market news, to predict how an asset’s price might move.
• Technical analysis, by contrast, relies on various sets of data and indicators, such as price and volume, to identify patterns and trends.
The stochastic oscillator is a key tool in securities trading and self-directed investing, because it uses support and resistance levels to gauge the momentum behind a certain price trend, and from there the potential for a reversal.
This tool plots one line, the %K line (which indicates the current price) against the %D line, which is a three-day moving average of the price. Although the two lines mirror each other to a degree, the %D line essentially smoothes out any volatility in the %K line in order to help traders evaluate the strength of the trend line.
Thus the stochastic oscillator, or sto indicator, is an indicator used in trading to assess trend strength.
History of the Stochastic Oscillator
The stochastic oscillator was created in the 1950s by George Lane, a securities trader, educator, author, and technical analyst. His famous observation about momentum and price informed his development of the stochastic oscillator: “Stochastics measures the momentum of price. If you visualize a rocket going up in the air, before it can turn down, it must slow down. Momentum always changes direction before price.”
The stochastic oscillator is now a common technical indicator that investors use to evaluate a variety of assets in many online investing platforms and price chart services.
How Does a Stochastic Oscillator Work?
The stochastic oscillator is a range-bound indicator, from 0 to 100. It has two moving lines that oscillate between and around two horizontal lines that indicate the oversold and overbought levels: 20 at the lower range and 80 at the upper range.
As noted above, the primary “fast” moving line is called the %K and reflects the security’s current value, while the other “slow” line is a three-period moving average of the %K line.
The full stochastic oscillator is a line customized by the user when they seek to buy stocks online (or with a regular broker) that may combine the traits of the slow and fast stochastics.
Slow vs Fast Stochastics
A signal is generated when the “fast” %K line diverges above the “slow” line or vice versa. The two horizontal lines are often pre-set at 20 and 80, indicating oversold and overbought levels, respectively, but can be modified to other levels, to reduce the risk of entering trades on false or premature signals.
The price is considered “overbought” when the two moving lines rise above the upper horizontal line and “oversold” when they fall below the lower horizontal line. The overbought line indicates price action that exceeds the top 20% (or 30%) of the recent price range over a defined period — typically 14-interval period. Conversely, the oversold line represents price levels that fit into the bottom 20% of the recent price range.
The stochastic oscillator is a form of stock technical analysis that traders can use to help identify potential trade entries and exits. When both stochastics are above the ‘overbought’ line (typically 80) and the fast %K line crosses below the slow %D line, this may signify a time to exit a long position or initiate a short position.
Conversely, when both stochastics are below the oversold line (typically 20), and the %K line crosses above the %D line, this could signify a time to exit a short position or initiate a new long position.
The stochastic oscillator is especially useful among commonly day-traded assets such as low-float stocks that have limited amounts of shares and are more volatile.
However useful these indicators are for determining entry and exit points, most traders use them in connection with other tools. While a stochastic oscillator is useful for implementing an overall strategy, it does not help identify overall market sentiment or broad market trends.
It is only when the trend or sideways trading range is well established that traders can safely and reliably use the stochastic oscillator to look for long entries in oversold conditions and shorts entries in overbought conditions.
What Is the Formula for a Stochastic Oscillator?
Below is the calculation for a standard 14-period stochastic indicator, but the time period can be adjusted for any time frame.
Calculation for %K:
%K = [(C – L14) / H14 -L14)] x 100
Key:
C = Latest closing price
L14 = Lowest low over the period
H14 = Highest high over the period
%K is sometimes referred to as the “fast stochastic”, whereas the “slow” stochastic indicator is defined as %D = 3-period moving of %K.
The general idea for this oscillator is that in an uptrending market prices will close near the indicator’s high, and in a downtrending market prices will close near the low. Trade signals are generated when the “fast” %K line crosses above or below the three-period moving average, or “slow” %D.
Pros of the Stochastic Oscillator
There are several benefits to using the stochastic oscillator when evaluating investments.
Clear Entry/Exit Signals
The oscillator generates visual signals when it exceeds upper or lower price boundaries, which can help a trader determine when it’s time to buy or when to sell stocks.
Frequent Signals
For active traders who rely on intraday charts such as the 5-, 10-, or 15-minute time frames, the stochastic oscillator generates signals more often as price action oscillates in smaller ranges.
Clarity
The oscillator’s fluctuating lines ranging from 0 to 100 are fairly clear for investors who know how to use them.
Available on Most Trading Platforms
The stochastic oscillator is a ubiquitous technical indicator found in many trading platforms, online brokerages, and technical chart services with similar configurations.
Recommended: How to Open a Brokerage Account
Cons of the Stochastic Oscillator
Despite its benefits, the stochastic oscillator is not a perfect tool.
Potential False Signals
Depending on the time periods chosen, traders may identify a sharp oscillation as a buy or sell signal, especially if it goes against the trend. This is more common during periods of market volatility.
Doesn’t Capture the Trend
The stochastic oscillator may calculate the strength or weakness of price action in the market, not the overall trend or direction for the security.
How to Trade With the Stochastic Oscillator
Some traders find the stochastic oscillator indicator useful to identify trade entry and exit points, and help decide whether they’re bullish on a stock. The stochastic oscillator does this by comparing a particular closing price based on the user’s selected time frame to a range of the security’s highest and lowest prices over a certain period of time.
Traders can reduce the sensitivity of the oscillator to market fluctuations by adjusting the time frame and range of prices. The oscillator tends to trend around a mean price level because it relies on recent price history, but it also adjusts (with lag) when prices break out of price ranges.
The Takeaway
The stochastic oscillator is a popular technical tool, which can help investors find trading opportunities. After identifying the direction of a security’s trend, the stochastic oscillator can help determine when the security is overbought or oversold, thus identifying lower-risk trade-entry points.
While technical indicators are not trading strategies on their own, they are useful tools when properly incorporated into an overall trading strategy.
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FAQ
What does a stochastic oscillator tell you?
By using this tool to track a security’s price movements, the stochastic oscillator may help traders spot pivotal price points that could signal a trend reversal.
Which is more accurate, RSI or stochastic oscillator?
Relative strength index, or RSI, tends to be more useful for investors in trending markets, whereas stochastics tend to be more helpful or reliable in non-trending markets.
What is divergence in stochastics?
Divergences are indications of a change, and can be used by traders or investors to try and determine whether a trend is getting weaker, stronger, or continuing.
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