(See my special off at the bottom of the page)
The Stochastic Oscillator is a momentum indicator that compares the closing price to the price range over a given time period. In other words it shows the close relative to the range over a set number of periods.
In a bull trend prices should tend to close near the upper end of the range. In a bear trend, prices tend to close near the low of the range. Therefore the Stochastic Oscillator is designed to follow the speed or momentum of the market.
The stochastic oscillator contains two lines. The first line is the %K, which is essentially the raw measure used to formulate the idea of momentum behind the oscillator. The second line is the %D, which is simply a moving average of the %K.
The %D line is considered to be the more important of the two lines as it is seen to produce better signals. The stochastic oscillator generally uses the past 14 trading periods in its calculation.
As a rule, momentum changes direction before the trend, therefore divergences in the Stochastic Oscillator can be used to indicate potential reversals in trends.
If the Stochastic Oscillator is starting to turn lower in a bull trend or is having lower highs when price is showing higher highs, this indicates that momentum is changing.
Price is failing to close in the upper area of the range despite the continuation of the bull trend.
This is my favourite indicator and I also find it useful for identifying overbought and oversold levels. Note: I only follow the slow Stochastic Oscillator.
The Stochastic Oscillator is above 50 when the close is in the upper half of the range and below 50 when the close is in the lower half. Low readings (below 20) indicate that price is near its low for the given time period.
High readings (above 80) indicate that price is near its high for the given time period.
The stochastic as an overbought & oversold indicator.
The oscillator ranges from 0 to 100, making it easy to identify overbought and oversold levels. No matter how fast or how far a market moves, the Stochastic Oscillator will always fluctuate within this range.
Traditional settings use 80 as the overbought threshold and 20 as the oversold threshold. Readings above 80 for the 20-day Stochastic Oscillator would indicate that the underlying security was trading near the top of its 20-day high-low range.
Readings below 20 occur when a security is trading at the low end of its high-low range.
It is important to note that oversold readings are not necessarily bullish and markets will remain oversold for long periods of time in a bear trend. Closing levels consistently near the bottom of the range indicate sustained selling pressure.
Watch for big red bodied candles!
Overbought readings are not necessarily bearish. A market can and will remain overbought for very long periods of time in a bull trend. Closing levels that are consistently near the top of the range indicate sustained buying pressure.
Watch for big blue bodied candles!
In the chart below you can clearly see the strong bull trend indicated by a red trend line, to the right of the chart. The stochastic becomes overbought at an early stage of the rally & remains severely overbought.
A trader selling in to shorts in this bull trend would potentially wipe out his account and many traders have made this mistake!
Therefore the Stochastic Oscillator must only be used as a potential buy signal (when combined with other technical analysis tools) in a bull trend or a sideways trending market.
See point A and B in the chart example above.
If the market experiences a negative short term correction in a longer term bull trend and becomes oversold on the Stochastic Oscillator, this could present an opportunity to buy back in to longs.
Ideally a trader will be looking for suitable support levels to enter this trade, rather than just buy blindly. A bounce from oversold conditions in a bull trend can often be very steep offering quick profits.
Note that when the stochastic crosses back above the blue 20 line in the example above, this acts as confirmation of a potential move higher. Some traders would use this as a buy signal,
confident that the bull trend has resumed.
The Stochastic Oscillator must only be used as a potential sell signal (when combined with other technical analysis tools) in a bear trend or a sideways trending market.
If a market experiences a bullish correction in a longer term bear trend and becomes overbought on the Stochastic Oscillator, this could present an opportunity to sell short.
Ideally a trader will be looking for suitable resistance levels to enter this trade. Or in a reverse of the bullish example above, a cross below the 80 line could be used as the sell signal,
indicating that the bear trend has resumed.
Bull & Bear Divergences.
A negative or bearish divergence forms when a new high in a bull trend is not confirmed with a new high in the Stochastic Oscillator. This shows decreasing upward momentum in the trend & could indicate a potential reversal.
In other words, a bearish divergence forms when price hits a higher high, but the Stochastic Oscillator forms a lower high.
For timing purposes we would look for a bearish confirmation, such as a break below an upward sloping trend line coupled with the stochastic crossing below the 80 line, before entering a short trade.
Just as a market can remain overbought for long periods of time, several bearish divergences can form & timing a sell off on the bearish divergence alone is too risky.
Wait for confirmation from candle formations and other technical analysis tools! See example below.
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 indicate a potential bullish reversal.
The half way point or 50 level on the Stochastic Oscillator is also worth watching. A Stochastic Oscillator cross above 50 signals that prices are trading in the upper half of their range for the given period
and is an added positive signal or confirmation of a continued move higher.
A cross below 50 means prices are trading in the bottom half of the period and suggests an added negative signal or confirmation of a continued move lower. In fact the half way mark can act as a support or resistance area.
This is not the strongest of signals but just keep an eye on it for confirmation of the trend!
Like all technical indicators, it is important to use the Stochastic Oscillator in conjunction with other technical analysis tools.
Volume, support/resistance and breakouts can be used to confirm or refute signals produced by the Stochastic Oscillator.
Using the stochastic to generate trade signals.
So you should be familiar with how the Stochastic Oscillator is used to identify the momentum of a trend & how it can be used as an overbought or oversold indicator.
We have seen how once a divergence is spotted we can use confirmation in price to generate a tradable signal.
Crossovers are commonly used to identify other buy and sell signals. In the chart example below see how signals are generated when the fast blue line crosses below the slow red line, when prices are overbought.
A break below the 80 line helps to confirm the negative signal or can in itself be used to trigger a sell signal.
Watch out for false signals – remember selling short in a bull trend is high risk & therefore we are likely to get false signals.
A bullish crossover of the fast blue line above the slow red line, when price is oversold triggers a buy signal.
This is a low risk buy signal as the market is in a longer term bull trend.
A cross of both lines back above the 20 line is an added buy signal.
Remember to use these signals with your other technical analysis tools to build a picture of what is happening with price
and when to trade it in the direction of the prevailing trend.