Created by George C. Lane in the late 1950s, the Stochastic Oscillator is a momentum indicator that indicates the position of the close compared to the high-low range with a set number of periods.
It tracks the rate or the momentum of price. Most of the time, the momentum changes direction before price. Consequently, bullish and bearish divergences in the Stochastic Oscillator enable you to foreshadow reversals. This was the first, and most significant, alert that Lane determined. Lane also used this oscillator to spot bull and bear set-ups to forecast a future reversal. For the reason that the Stochastic Oscillator is range bound, it is usually helpful for finding overbought and oversold levels.
The most widely used setting for the Stochastic Oscillator is 14 periods, which can be days, weeks, months or an intraday timeframe. A 14-period %K would use the most recent close, the highest high over the last 14 periods and the lowest low over the last 14 periods. %D is a 3-day simple moving average of %K. This line is plotted alongside %K to act as a signal or trigger line.
Transaction signals occur when the %K crosses through a three-period moving average called the %D.
When the Stochastic is above 80, a stock or market is overbought.
When the Stochastic stays above 80 it means the uptrend is strong.
When the Stochastic breaks below the 80 level, expect a downward correction or the start of a new downtrend.
When the Stochastic is below 20, a stock or market is oversold.
When the Stochastic stays below 20, it means the downtrend is strong.
When the Stochastic breaks above 20, expect an upward correction or the start of a new uptrend.
There are many different trading strategies for use with the Stochastic Oscillator but among the best is the Overbought Oversold method.
First establish the larger trend in the stock or market you are trading.
Create your Stochastic overlay using the Full Stochastic and a setting of 14 and 3.
The Stochastic gives a buy signal when it breaks above the 20 line.
It gives a sell signal when it breaks below the 80 line.
Another popular trading method that uses the Stochastic Oscillator is called the Crossover method.
When the %K line from above crosses the %D line downwards it is a sell signal.
When the %K line from below crosses the %D line upwards, it is a buy signal.
Stochastic line crossovers that happen above the 80% level and below the 20% level are treated as the strongest signals when compared to crossovers outside these areas.
Swing traders may want to increase the sensitivity of the Stochastic Oscillator by using a 5,3 setting which is better for trading rapidly changing markets.
The third most popular method of trading with the Stochastic Oscillator is called the Divergence method.
If the price of a stock is making new highs but the Stochastic is making new lows, a negative divergence has taken place and it means the price of the stock is likely to drop.
If the price of a stock is making new lows but the Stochastic is making new highs, a positive divergence has taken place and it means the price of the stock is likely to jump higher.
The goal of this strategy is to look for a divergence between the price of a stock and the Stochastic Oscillator.
Below is a quick video tutorial of the Stochastic Oscillator.
For another great article on the Stochastic, go to Stochastic Indicator