Understanding the Stochastic Oscillator

Do you still feel confused when you see technical analysis tools? Do not worry, you are not alone. Being a beginner, understanding technical charts can feel confusing. But it is also important to have knowledge of these for identifying market reversals.

In 1950, technical analyst George Lane introduced a technical analysis tool, known as the stochastic oscillator. This tool helps you identify market reversals while comparing an asset’s closing price with its price range. Let us discuss what is stochastic oscillator, its calculation, advantages, and disadvantages.

What Does a Stochastic Oscillator Mean?

A stochastic oscillator is a momentum indicator which compares an asset’s closing price with a range of its prices in a specific time period. However, you can reduce the sensitivity of this stochastic oscillator to market movements by adjusting the time period or by considering a moving average of the outcome.

You can use it to spot overbought and oversold signals of an asset, with a 0-100 bounded range of values. The primary reason behind introducing the stochastic oscillator is to uphold the fact that price momentum always changes before there is a change in price.

How a Stochastic Oscillator Works?

The stochastic oscillator makes a comparison of a particular closing price of an asset to a wide range of high and low prices over a specific period of time. You can calculate the stochastic oscillator using 14 days as the standard.

However, you have the flexibility to adjust the time period to suit specific requirements. The value of the stochastic oscillator indicator for any specific time period always remains between 0 and 100.

How to Calculate the Stochastic Oscillator?

The calculation of the stochastic indicator is very simple to understand. This indicator uses two different formulae to calculate the values:

1. K-Line Formula

   %K = 100 x (CP – L14) / (H14 – L14)

   In this formula,

   1. CP = most recent closing price
   2. L14 = lowest trading price of an asset in the previous 14 trading sessions
   3. H14 = highest trading price of an asset in the previous 14 trading sessions

   4. D-Line Formula

   %D = 100 x (H3/L3)

   In this formula,

   1. H3 = highest trading price of an asset in the previous 3 trading sessions
   2. L3 = lowest trading price of an asset in the previous 3 trading sessions

Here, %K is a slow-moving indicator, and %D is a fast-moving indicator. %D is calculated by the 3-period moving average of %K.

The general rule of thumb of the stochastic oscillator shows that when the price of an asset closes near highs, it is in a market uptrend. The value of the stochastic oscillator will close near low when the market is moving in a downward trend.

To spot any major indication in the price charts of an asset, the indicator uses both the K line and the D line formulas in tandem.

How Can You Use the Stochastic Oscillator in Trading?

You can use the stochastic oscillator in numerous ways while trading assets, which are explained below:

1. Identifying Overbought and Oversold Levels

   When you see the stochastic indicator above 80, it may indicate an overbought level. However, if it comes below 20, then it indicates oversold conditions in the market.

   When the stochastic oscillator goes above 80 and then returns below 80, you can consider it a sell signal. On the other hand, a buying signal is generated when the oscillator goes below 20 and then comes back above 20.

2. Crossovers

   Crossovers are the intersecting points of the fast stochastic line and the slow stochastic line. The slow stochastic line is %D, and the fast stochastic line is 0%K. When the %K line intersects the %D line and goes above it, this indicates a bullish scenario. Additionally, when the %K line crosses from above to below, the %D stochastic line provides a bearish sell signal.

• Divergence

  Divergence happens when the price of an asset is making a new high or low, which is not seen on the stochastic oscillator. For example, when a price reaches a new high, the oscillator does not follow the pace. This is an illustration of bearish divergence, which might indicate that the market is about to reverse from an upward to a downward trend. The oscillator’s inability to reach a new high with price action suggests that the uptrend’s impetus is beginning to weaken.

  In the same manner, a bullish divergence happens when the oscillator does not move to a new low reading in response to the market price making a new low. A potential upcoming upward market reversal is indicated by bullish divergence.

  It is crucial to remember that the stochastic oscillator may provide a divergence indication before a shift in the direction of market activity. For example, if the oscillator indicates a bearish divergence, the price may rise for a few trading sessions before declining. For this reason, Lane advises against starting a trading position until there is some indication of a market reversal. Divergence should not be the sole basis for a trade.

Advantages of the Stochastic Oscillator

1. Simplicity

   The stochastic oscillator is very simple to understand. With readings between 0 and 100, you can recognise overbought and oversold situations with ease. An asset is overbought if the reading is higher than 80, and oversold if it is lower than 20.

2. Overbought and Oversold Identification

   This tool is useful for spotting market sentiments that might lead to a price reversal.

3. Detects Divergence

   Early indicators of possible trend reversals can be seen in the divergence between the price and the stochastic oscillator.

4. Effective in Range-Bound Markets

   The stochastic oscillator allows traders to profit from price fluctuations between support and resistance levels.

5. Indicator Combination

   To improve the accuracy of trading signals, you can use the oscillator with additional technical indicators like moving averages.

6. Confirmation with Support and Resistance Levels

   You can use the support and resistance levels with the stochastic oscillator to verify signals. The signal is strengthened when the %K line or %D line hits an extreme level, such as over 80 or below 20, and corresponds with a notable level of support or resistance.

This convergence of several indications increases the likelihood of a profitable transaction and helps traders make more certain choices.

Disadvantages of the Stochastic Oscillator

1. Lagging Indicator

   Although the stochastic oscillator is useful in spotting possible reversals, it is still a lagging indicator. When prices are moving quickly, it cannot deliver timely indications, which would make you lose out on opportunities.

2. Optimisation Problems

   The choice of parameters can affect how effective the stochastic oscillator is. It might be time-consuming for traders to tune these settings for various assets and periods.

3. Ineffectiveness in Strong Trends

   The stochastic oscillator is less helpful for timing entry and exits in strongly moving markets since it can stay in overbought or oversold areas for lengthy periods of time.

4. Subjectivity

   Stochastic oscillator signals can be interpreted subjectively, much like many other technical indicators. Based on this oscillator, traders may have different entry and exit criteria.

Relationship Between Stochastic Oscillator and Relative Strength Index

Another technical indicator that closely resembles the stochastic indicator is the Relative Strength Index (RSI). You can frequently employ both of these instruments, which are price momentum oscillators. Traders frequently combine the RSI and the stochastic oscillator to improve the accuracy of a buy or sell recommendation.

These two technical indicators may have similar purposes, but their underlying ideas differ. The idea behind the stochastic oscillator is that an asset’s price tends to close near its highs during market uptrends and close near its lows during market downturns.

In contrast, RSI measures the speed at which an asset’s price fluctuates. The RSI can be a valuable tool for identifying overbought and oversold conditions in a market that tends to move in trends. On the other hand, the stochastic indicator is more useful when the stock market exhibits erratic movements.

Final Thought

Traders often use the stochastic oscillator and its divergence signals to identify possible market reversal points. However, you might face difficulties while relying only on it, since it is prone to generating false indications. Therefore, you can use the stochastic oscillator with other technical indicators.

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Frequently Asked Questions

1. What is stochastic 14-3-3?

The stochastic 14-3-3 indicator uses closing prices to assess market momentum. The closing prices continuously fall in the upper half of the historical high-low range in a 14-period. The value of the stochastic oscillator 14-3-3 increases. This uptrend in a market indicates a rise in momentum.

2. How can you read the Stochastic Oscillator?

You can read a stochastic oscillator scaling between 0 and 100. Reading above 80 means that an asset is trading close to the upper end of its historical price range.

3. What is the formula using the stochastic oscillator?

The formula of a stochastic oscillator is:

%K = 100 x (Recent closing price – lowest trading price of previous 14 sessions) / (highest trading price of previous 14 sessions – lowest trading price of previous 14 sessions)

%D = 100 x highest trading price of previous 3 sessions / lowest trading price of previous 3 sessions)

4. Is a stochastic oscillator an effective indicator?

A stochastic oscillator is an effective indicator which helps to identify price changes and momentum shifts. However, it becomes more powerful when you can use it with other technical indicators.