What is a Stochastic Oscillator? Indicator formula and trading strategies

What is a Stochastic Oscillator? Full guide to the indicator: how it works, calculation formula and trading strategies
Being one of the most widespread trading indicators, the stochastic oscillator is commonly used to forecast trend direction and reversals. It is based on price momentum and allows traders to see oversold and overbought zones in the whole gamut of assets (indices, currencies, and so on). In this guide, you will find out how the Stochastic works, learn to calculate it and use it in your trading strategies.

What is the Stochastic Oscillator?

The stochastic oscillator is a momentum indicator that compares the last closing price with the previous trading range over a particular period. What makes it stand out from other indicators is that Stochastic is not based on asset’s volume or price - it takes into consideration the speed and momentum of the market.

It was created in the 1950-s by George Lane, a famous trader and economist. When developing the indicator, he laid the basis for Momentum, that is, how much the price amplitude changes. It is calculated as the difference between the price now and the one that was a certain time ago. According to Lane, when Momentum changes, the price changes immediately after it.

Thus, stochastic indicator is considered to be a leading one: it is commonly used by traders to predict prices and make informed trading decisions.

Stochastic Indicator Formula

All calculations are made automatically in a fraction of a second, as soon as you put the indicator on the chart in the trading terminal. But how did George Lane calculate it manually?

There are two lines %K and %D on the scale of the stochastic indicator. They are calculated as follows:

%K = (Closing price at the current moment - Local minimum for the selected time period) / (Local maximum for the selected period - Local minimum for the same time interval) *100.

%D = this is a classic indicator Simple Moving Average SMA, which is taken over a certain period of time %K.

In other words, there are two lines on the scale, where %K is fast, %D is slow.

Visually, they move approximately next to each other on a scale from 0 to 100. %K displays the closing price in relation to the specified time interval, and %D is the classic MA.

A full-fledged indicator is built on the basis of three parameters:

• Period for plotting %K
• Smoothing factor
• Period to determine %D

But the modern version of the indicator is an average tool between the first two parameters.

What Does the Stochastic Oscillator Tell You?

Like RSI, this indicator ranges from 0 to 100 and helps you determine when a trend is overbought or oversold and when a trend is starting or ending. However, stochastic is considered to provide more accurate trading signals than the RSI.

Stochastic consists of two lines: %D (slow black line) and %K (fast gray line). In this connection, it has two speeds: fast and slow.

When choosing between Fast Stochastic and Slow Stochastic, it is better to start with the slow one, as it gives fewer signals. Its major disadvantage is that the signals will arrive with some delay compared to the fast stochastic.

The most popular signal given by the stochastic occurs when the slower %D line rises above 80 or falls below 20. This is an important signal that the index or a particular stock is overbought or oversold.

However, it is important to remember that, like the RSI, the stochastic indicator can remain overbought or oversold for a long time and just because the market has entered a “danger zone” does not mean that it should reverse soon.

What is Momentum?

Momentum is a key concept for determining the likelihood of a profitable trade. Momentum measurements can be used in the short and long term, making them useful for all types of trading strategies.

In simple words, momentum is the rate of acceleration of the security price.

The momentum indicator is a popular tool used to determine the momentum of a particular asset. This is a graphical device that is often used in the form of an oscillator: it shows how fast the price of a given asset is moving in a certain direction and whether the price movement will continue going along its trajectory.

Why Does Momentum Matter?

It allows us to analyze the speed of market trend development. For example, when the market is in uptrend and momentum slows down, it may mean that the trend is getting weaker, and reversal is coming. Hence, momentum helps traders define whether the market is going to continue, or the trend can be extended over some direction (overbought or oversold).

How to Use the Stochastic Oscillator in Trading

Let’s observe a few common cases with the stochastic. By interpreting its numbers, you can predict market movements and close or open deals at the right moment.

Stochastic Overbought/Oversold Strategy

By applying this strategy, traders can define the right entry and exit points.

Here’s how it works:

• If %D (solid black line) rises above 80, look for a sell opportunity - the asset is overbought. If the %D line falls below 20 and starts turning up, look for a buy opportunity - the asset is oversold.
• If the stochastic oscillator closes near the high (for example, above 80), this may indicate a short-term uptrend for the security.
• On the opposite, if the closing price of a stock or index is close to the low (below 25, for example), it may signal a short-term downtrend.

Note that overbought and oversold zones may be misleading. An asset may not experience trend reversal simply because of the Stochastic oscillator values. Such conditions can last for a while.

Stochastic Divergence Strategy

Unlike the RSI, the stochastic oscillator divergence gives a more reliable signal, but its should be double-checked in combination with other indicators.

In addition, some traders use the stochastic as a filter to enter a position. They will not buy a security if they see the divergence of the lines of the oscillator itself (meaning the situation when %D and %K diverge from each other). Divergence is when the price goes in one direction, and the Stochastic goes in another. It signals that the price movement will change dramatically very soon.

As you can see on the chart - the price goes down, and the Stochastic breaks up. This is the divergence. Now, you need to wait until the price reaches the minimum level and the growth begins - this is where you buy the Call option.

The example above is a bullish divergence: the price makes lower lows while the stochastic indicator touches higher lows. On the opposite bearish divergence happens when the price keeps going up while the stochastic indicator hits lower highs. That means momentum is slowing down, and the trend may change.

Note that in this case, trades should not be performed until the moment when you confirm upcoming price changes. Price may keep falling or increasing while stochastic divergence is occurring.

Stochastic Crossover

This is another widespread strategy practiced by traders - it takes place when two lines cross in an overbought or oversold zone.

For example, when the increasing %K line crosses above the %D line in the oversold region, you see a buy signal. When the decreasing %K line crosses below the %D line in the overbought zone, this is a sell signal - you can see it on the chart below (%K is blue, %D is red):

Note that these signals tend to be more reliable in the sideways market, but not in a trending market. When you keep following a trend, make sure that the stochastic stays crossed in one direction - it proves that the trend continues.

Stochastic Bull/Bear Strategy

It implies the intersection of the basic levels by the main line of the Stochastic on a strong trend, that is:

• On an uptrend: a breakdown of the overbought level of 70(80) is the first signal of a slowdown in growth and a possible downward reversal. Traders usually buy after a price pullback when the stochastic indicator gets below 50 and moves higher again.
• On a bear set-up: a breakdown of the oversold border 30(20) on a downtrend is a signal for fixing sales and a possible upward reversal.When the stochastic oscillator makes a lower low but the asset price makes higher lows, the selling pressure is increasing and it’s time to sell after a short price rebound.

It is also recommended to pay attention to the shape of the “in the zone” reversal: if the stochastic lines form a sharp reversal, the subsequent movement should be strong and sharp. If the level is broken after a flat in the critical zone (“wide reversal”) – the trend is weaker, but stable.

Note that during a choppy market, this oscillator may provide false signals, so you should use other instruments to prove your predictions.

The Relative Strength Index (RSI) vs. The Stochastic Oscillator

Both stochastic oscillator and RSI are momentum indicators that are commonly used for technical analysis. Although they are often used in combination, the calculation formulas and approaches underlying them are different.

The stochastic oscillator is based on the theory that closing prices should close near the same direction as the current trend. RSI, in its turn, tracks oversold and overbought levels by measuring price fluctuations. Hence, RSI evaluates the speed of price changes and proves useful during trending markets, while the stochastic oscillator is best for trading ranges and sideways markets.

Combining the Stochastic with Other Tools

To boost the efficiency of your trading strategy, it’s highly recommended to use stochastic oscillator with the following instruments:

• Moving averages. These lines can serve as filters for your signals. It’s highly recommended to trade in the direction of moving averages, and while the price keeps above these levels, always look for longs (and vice versa).
• Price formations. When anticipating trend reversals or breakouts, you should look for patterns: triangles, rectangles, head & shoulders, and so on. When price breaks out of the formation supported by an accelerating stochastic, you may witness a successful breakout.
• Trendlines. This is a perfect addition to your Stochastic reversal or divergence. You need to discover an established trend with a valid trendline and wait for a price breakout, which will confirm your Stochastic.

Limitations of the Stochastic Oscillator

The major drawback of the oscillator is the risk of receiving false signals, which is especially true during a highly volatile market. For this reason, it is crucial to use the Stochastic in combination with other signals.

Traders should always remember that the oscillator is used to measure strength or weakness of the trend, but not its direction or price movement. Some traders tend to interpret wrong signals when they see extreme readings (below 15 and above 85) - those are not very reliable readings when used separately from other trading oscillators.

Summary

The stochastic oscillator is a must-have in the tool arsenal of any trader, beginner or pro. This indicator allows traders to define the current market trend when the price does not show any prominent ups or downs. This instrument is particularly useful during a sideways market and when you want to analyze the asset based on its price highs and lows.

You can use the stochastic oscillator for different time frames, be it day trading or long-term deals. However, don’t forget that this oscillator alone may generate false signals, so you should always apply it in combination with other tools, such as RSI, Moving Averages and trendlines.