- Type of Indicator: Momentum
- Creator: George C. Lane
- When Created: 1950s
- First Mentioned In: George C. Lane introduced the Stochastic Oscillator in a series of seminars and courses in the late 1950s and early 1960s.
What Is The Stochastic?
The Stochastic Oscillator is a momentum-based technical analysis indicator developed by George C. Lane. It compares a security’s closing price to its price range over a specified period, typically 14 days.
Called Stoch for short, the Stochastic Oscillator consists of two lines: %K, the main line, and %D, a moving average of %K.
The indicator ranges between 0 and 100 providing a variety of signals. It is primarily used to identify overbought and oversold conditions, potential trend reversals, and divergences.
The Stochastic operates on the premise that, in an uptrend, prices tend to close near the high of the price range, while in a downtrend, prices tend to close near the low of the price range. The indicator can be further categorized into two types: fast stochastic and slow stochastic.
How Do You Read The Stochastic?
The Stoch provides traders with information about the momentum and possible reversals in an asset’s price.
When the %K line is above 80, it indicates that the asset may be overbought, signaling a potential price decline.
Conversely, when the %K line is below 20, it indicates that the asset may be oversold, signaling a potential price increase.
Traders also look for crossovers between the %K and %D lines to identify potential trading signals.
A bullish crossover occurs when the %K line crosses above the %D line, suggesting a possible upward price movement
A bearish crossover occurs when the %K line crosses below the %D line, suggesting a possible downward price movement.
How Does The Stochastic Work?
The Stoch works by comparing the closing price of an asset to its price range over a specified number of periods.
The %K line represents the current closing price relative to the high and low of the price range, while the %D line is a moving average of the %K line.
How Is The Stoch Calculated?
%K = [(Current Close – Lowest Low) / (Highest High – Lowest Low)] * 100
%D = n-period Simple Moving Average of %K
The Encyclopedia Of Technical Market Indicators, Second Edition
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Overbought/Oversold Levels: A buy signal occurs when the %K line moves below 20 (oversold), then crosses above the %D line. A sell signal occurs when the %K line moves above 80 (overbought), then crosses below the %D line.
Bullish/Bearish Crossovers: A bullish crossover occurs when the %K line crosses above the %D line, signaling a potential upward price movement. A bearish crossover occurs when the %K line crosses below the %D line, signaling a potential downward price movement.
Divergences: Bullish divergences occur when the price makes a lower low, but the oscillator makes a higher low. Bearish divergences occur when the price makes a higher high, but the oscillator makes a lower high. Divergences can signal potential trend reversals.
Additional Trading & Risk Management Tips
Use the Stochastic in conjunction with other technical indicators and chart patterns to improve the accuracy of your trading signals.
Be cautious when relying solely on the Stoch, as it can generate false signals in certain market conditions, such as during strong price reversals or volatile, choppy markets.
Adjust the lookback period for calculating the Stochastic to suit your specific trading style and the market you are analyzing. Shorter lookback periods will make the indicator more sensitive to price changes. Longer lookback periods will make it less sensitive.
Test the oscillator on historical data to evaluate its effectiveness for your specific trading style and market conditions before incorporating it into your live trading strategy.
Practice proper risk management techniques to protect your investments, and always consider other factors in addition to the Stochastic Oscillator when making trading decisions.
Consider using the tool in conjunction with support and resistance levels or trendlines to confirm potential entry and exit points or to identify areas of confluence.
Use the Stoch in combination with other momentum or trend-following indicators to confirm the strength and direction of the trend. This potentially leads to more accurate and reliable trading signals.
Be aware that the indicator may perform differently in different market conditions. It’s essential to stay flexible and adapt your trading strategy as needed.
Keep in mind that the Stochastic Oscillator is a lagging indicator, which means it reflects past price movements and may not accurately predict future price movements.
Traders should also take into consideration other technical analysis tools, such as chart patterns, candlestick patterns, and other indicators, when making trading decisions.
Practice using the Stochastic using a TradingView account to backtest performance.