What it is, how it works, how to calculate

What is a stochastic oscillator?

A stochastic oscillator is a momentum indicator that compares a particular closing price of a security to a range of its prices over a certain period of time. The sensitivity of the oscillator to market movements can be reduced by adjusting that period or by taking a moving average of the result. It is used to generate overbought and oversold trading signals, with a 0-100 bounded range of values.

Understanding the Stochastic Oscillator

The stochastic oscillator is range bound, meaning it is always between 0 and 100. This makes it a useful indicator of overbought and oversold conditions.

Traditionally, readings above 80 are considered in the overbought range, and readings below 20 are considered oversold. However, this is not always an indication of impending reversal; very strong trends can maintain overbought or oversold conditions for a long period of time. Instead, traders should look to changes in the stochastic oscillator for clues about future trend shifts.

Stochastic oscillator charting generally consists of two lines: one that reflects the actual value of the oscillator for each session, and one that reflects its three-day simple moving average. Because price is thought to follow momentum, the intersection of these two lines is considered a signal that a reversal may be in the works, as it indicates a major shift in momentum from day to day.

Divergence between the stochastic oscillator and trend price action is also seen as an important reversal signal. For example, when a bearish trend makes a new lower low, but the oscillator is pushing a higher low, it may be an indication that bears are exhausting their momentum and a bullish reversal is brewing.

Formula for the Stochastic Oscillator

%K = ( C − L14 H14 − L14 ) × 100 where: C = The most recent closing price L14 = The lowest price traded of the 14 previous trading sessions H14 = The highest price traded during the same 14-day period %K = The current value of the stochastic indicator \begin{aligned} &\text{\%K}=\left(\frac{\text{C} – \text{L14}}{\text{H14} – \text{L14 }}\ right)\times100\\ &\textbf{where:}\\ &\text{C = The most recent closing price}\\ &\text{L14 = The lowest price traded from the 14 previous}\\ & \text{trading sessions }\\ &\text{H14 = The highest price traded during the same}\\ &\text{14-day period}\\ &\text{\%K = The current value of the stochastic indicator }\\ \end{ align}

,%K=(H14−L14C−L14,)x100where:C = The most recent closing priceL14 = The lowest price traded of the 14 previoustrading sessionsH14 = The highest price traded during the same14 day period%K = The current value of the stochastic indicator,

%K is particularly referred to as the fast stochastic indicator. The “slow” stochastic indicator is taken as %D = 3-period moving average of %K.

The general theory underlying this indicator is that in an uptrending market, prices will close near the high, and in a downtrending market, prices will close near the low. Transaction signals are created when the %K crosses through a three-period moving average, which is called the %D.

The difference between the slow and fast Stochastic Oscillator is the Slow %K incorporates a %K deceleration period of 3 which controls the internal smoothing of %K. Setting the smoothing period to 1 is equivalent to plotting the Fast Stochastic Oscillator.

History of the Stochastic Oscillator

The stochastic oscillator was developed by George Lane in the late 1950s. As devised by Lane, the stochastic oscillator presents the location of the closing price of a stock relative to the high and low prices of the stock over a period of time, typically a 14-day period.

Lane has said over the course of numerous interviews that the stochastic oscillator does not follow price, volume, or anything similar. He indicates that the oscillator follows the speed or momentum of price.

Lane also reveals that, as a rule, the momentum or speed of a stock’s price movements changes before the price changes direction. In this way, the stochastic oscillator can predict reversals when the indicator reveals bullish or bearish divergences. This signal is the first, and probably the most important, trading signal Lane identified.

Example of the Stochastic Oscillator

The stochastic oscillator is included in most charting tools and can be easily used in practice. The standard period used is 14 days, although this can be adjusted to meet specific analytical needs. The stochastic oscillator is calculated by subtracting the low for the period from the current closing price, dividing the total range for the period and multiplying by 100.

As a hypothetical example, if the 14-day high is $150, the low is $125, and the current close is $145, then the reading for the current session would be: (145-125) / (150 – 125) * 100, or 80.

By comparing the current price with the passage of time, the stochastic oscillator reflects the consistency with which the price closes near its recent high or low. A reading of 80 would indicate that the asset is about to be overbought.

Relative Strength Index (RSI) vs Stochastic Oscillator

The relative strength index (RSI) and stochastic oscillator are both price momentum oscillators widely used in technical analysis. Although often used in tandem, they each have different underlying theories and methods. The stochastic oscillator is based on the assumption that closing prices should move in the same direction as the current trend.

Meanwhile, the RSI tracks overbought and oversold levels by measuring the velocity of price movements. In other words, the RSI is designed to measure the speed of price movements, while the stochastic oscillator formula works best in consistent trading ranges.

In general, the RSI is more useful during trending markets, and stochastic more so in sideways or range bound markets.

Limitations of the Stochastic Oscillator

The primary limitation of the stochastic oscillator is that it is known to produce spurious signals. This is when a trade signal is generated by the indicator, but the price does not actually follow through, which can end up as a losing trade. During volatile market conditions, this can happen quite often. One way to help with this is to take the price trend as a filter, where signals are only taken if they are in the same direction as the trend.