What Is the Stochastic Oscillator?

A stochastic oscillator is a momentum indicator developed by George Lane in the late 50s. It is a range-bound oscillator, which means that it is operating between 100 and 0 values. The indicator compares the closing price of an asset to its high-low range over a set number of periods. Its main purpose is to identify support and resistance levels and generate signals in overbought and oversold areas.

Calculation of the Stochastic Oscillator

The stochastic oscillator consists of two lines, %K and %D. The equations for calculating the two lines are the following

%K = 100 * (C - Lx) / (Hx - Lx)

%Dn = ((K1+K2+K3 + … +Kn) / n)

Where 

C = The most recent closing price

Hx and Lx are the highest and lowest prices in the last x periods

%D is the n-period moving average of %K 

The final outcome of the stochastic oscillator calculation is two curves with values between 0 to 100, and it is usually plotted on a chart below the main price chart. We can see an example of a plotted stochastic indicator from Fondex cTrader below.

To add a stochastic indicator in Fondex cTrader, right-click on the chart and navigate to Indicators > Oscillators > Stochastic Oscillator. After clicking on Stochastic Oscillator, the below form will appear. 

In this form you can select the %K and %D Periods, %K Slowing, the MA type, customize your line’s color thickness and type, set the overbought and oversold levels, and press OK. The stochastic indicator will be added to the bottom of your screen.  The form above shows the typical values used for the stochastic oscillator indicator.

What Does Stochastic Oscillator Tell You?

Stochastic oscillator is an indicator that displays the current market momentum and indicates if a market is in an overbought or in an oversold state. The typical values of an overbought market is > 80 and for an oversold market is < 20. Traders monitor the stochastic indicator to identify if the market is in a trending state and if a reversal or price correction is probable. For example, an intersection of the stochastic oscillator lines is sometimes considered a reversal signal, especially if this happens within the oversold or overbought areas. Based on the value of the stochastic oscillator and combined with other observations about the market state, successful trading strategies can be devised. We briefly present some examples of such strategies of them below.

Stochastic Crossover

A stochastic crossover happens when the %K line crosses above or below the %D line. A stochastic crossover can be considered as a signal for a price reversal when it happens within the overbought and oversold areas, since it indicates that a trend has probably finished and the price might be ready for entering a reverse course. In the chart below we can see some examples of crossovers happening in overbought and oversold areas.

The crossovers inside the yellow circles are the signals within these overbought and oversold areas. Nevertheless, something that can be clearly noticed on the chart is the fact that not all crossovers result in a valid signal, since the price does not reverse but at the end it continues in the same direction, prolonging the stay of the indicator inside the overbought and oversold areas. These signal cases would have resulted in unsuccessful trades. Hence, there is a possibility the stochastics oscillator will provide you with false positives if not traded in context e.g. in relation to a multi timeframe analysis that will identify the dominant trend or in line with the price action on the actual chart.

Stochastic Oscillator Divergence 

As mentioned above, the stochastic oscillator is a momentum indicator, trying to identify the current state of the market. Another popular method of trading the stochastic oscillator indicator is through detecting divergences between the stochastic oscillator and the price movement. A divergence is a scenario where the indicator is moving to the opposite direction of the price. A stochastic oscillator divergence happens when the two following events occur a) the price moves upwards, following a buying trend and forming higher highs, but the stochastic indicator forms lower highs b) the price moves downwards, following a selling trend and forming lower lows, but the stochastic indicator moves upwards, forming higher lows. A stochastic indicator divergence is an insight that the current price trend is fading out, making a reversal possible.

The chart below shows an example of a stochastic oscillator divergence

We can observe that the price is in a bearish trend forming new lower lows. The blue line inside the main chart connects these lower lows. At the same time the stochastic oscillator indicator is forming higher lows, diverging from the price trend. The blue line inside the indicator chart connects these higher lows. This divergence implies that despite the downtrend upward pressures start forming. The following price action and the sudden upward move confirms the validity of the signal. Stochastic oscillator divergence is useful in spotting reversal points, but your signal would also benefit by combining the divergence with some more confirming information, such as a reversal price pattern e.g. a morning star or a hanging man.

Limitations of the Stochastic Oscillator

The stochastic oscillator, as any other technical indicator, always needs to be used in context. An out of context interpretation of the stochastic oscillator patterns can generate a lot of false signals that could lead to substantial losses. Therefore, when using the stochastic oscillator, always consider the market fundamentals that currently move the market and combine the signals with other confirmation signals, like trend indicators, support/resistance levels and the relevant price action taking place on the chart.

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