Developed by George C. Lane in the late 1950s, the Stochastic Oscillator is a momentum indicator that shows the location of the close relative to the high-low range over a set number of periods. According to an interview with Lane,
The Stochastic Oscillator “doesn’t follow price, it doesn’t follow volume or anything like that. It follows the speed or the momentum of price.As a rule, the momentum changes direction before price.” As such, bullish and bearish divergences in the Stochastic Oscillator can be used to foreshadow reversals. This was the first, and most important, signal that Lane identifie dBecause the Stochastic Oscillator is range bound, is also useful for identifying overbought and oversold levels.
%K = (Current Close – Lowest Low) / (Highest High – Lowest Low) * 100
%D = 3-day Simple Moving Average (SMA) of %K
Lowest Low = Lowest Low for the look-back period
Highest High = Highest High for the look-back period
Note: %K is multiplied by 100 to move the decimal point two places
The default 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.
The Stochastic Oscillator generates signals in three main ways:
1. Extreme Values (Overbought Oversold)
2. Stochastic Crossovers
3. Stochastic Divergences
EXTREME VALUES OVERBOUGHT OVERSOLD
The Stochastic Oscillator ranges from zero to one hundred. No matter how fast a security advances or declines, the Stochastic Oscillator will always fluctuate within this range. Traditional settings use 80 as the overbought threshold indicating that the underlying security was trading near the top of its range and 20 as the oversold threshold indicating that the underlying security was trading at the low end of its range. These levels can be adjusted to suit analytical needs and security characteristics.
Note:It is important to note that overbought readings are not necessarily bearish. Securities can become overbought and remain overbought during a strong uptrend. Closing levels that are consistently near the top of the range indicate sustained buying pressure. In a similar vein, oversold readings are not necessarily bullish. Securities can also become oversold and remain oversold during a strong downtrend. Closing levels consistently near the bottom of the range indicate sustained selling pressure.
Buy when the %K line rises above the %D line.
Sell when the %K line falls below the %D line.
Beware of short-term crossovers that may generate false signals.
The preferred crossover is when the %K line intersects after the peak of the %D line (known as a right-hand crossover).
Divergence-convergence is an indication that the momentum in the market is waning and a reversal may be in the making.
Divergences form when a new high or low in price is not confirmed by the Stochastic Oscillator.
A bullish divergence forms when price records a lower low, but the Stochastic Oscillator forms a higher low. This shows less downside momentum that could foreshadow a bullish reversal.
A bearish divergence forms when price records a higher high, but the Stochastic Oscillator forms a lower high. This shows less upside momentum that could foreshadow a bearish reversal.
Once a divergence takes hold, chartists should look for a confirmation to signal an actual reversal. A bearish divergence can be confirmed with a support break on the price chart or a Stochastic Oscillator break below 50, which is the center line. A bullish divergence can be confirmed with a resistance break on the price chart or a Stochastic Oscillator break above 50.
The Stochastic Oscillator moves between zero and one hundred, which makes 50 the center line. Think of it as the 50 yard line in football. The offense has a higher chance of scoring when it crosses the 50 yard line. The defense has an edge as long as it prevents the offense from crossing the 50 yard line. A Stochastic Oscillator cross above 50 signals that prices are trading in the upper half of their high-low range for the given look-back period. This suggests that the cup is half full. Conversely, a cross below 50 means prices are trading in the bottom half of the given look-back period. This suggests that the cup is half empty.
The signal to act is when you have a divergence-convergence, in an extreme area, with a crossover on the right hand side, of a cycle bottom. As plain crossovers can occur frequently, one typically waits for crossovers occurring together with an extreme pullback, after a peak or trough in the %D line. If price volatility is high, an exponential moving average of the %D indicator may be taken, which tends to smooth out rapid fluctuations in price.