The stochastic oscillator is a momentum indicator that helps to show the current location of a security closing price relative to its high/low range. As a range bound momentum, it’s used for three things:
a. Identifying overbought and oversold levels
b. Spotting divergences
c. Identifying bull or bear signals
One thing you need to know is that the Stochastic Oscillator has withstood the test of time and has been in existence for over 60 years. As a result, it has become one of the best indicators for traders to use.
Stochastic Oscillator History
George Lane developed the Stochastic Oscillator in the late 1950s. He designed the trading tool to be used by traders to present location of the closing price for a particular security in relation to high and low range stock price over a period of time.
George Lane conducted several interviews revealing that the indicator does not follow price, volume or any other similar indicator. What the Stochastic Oscillator follows is the speed or price momentum.
Thanks to its ability to change before price changes, the Stochastic Oscillator can be utilized to foreshadow reversals thus revealing either bearish or bullish divergences.
Stochastic Oscillator Formula
In trading, the Stochastic Oscillator is measured using the %K and %D line. The %D line is what traders should be following closely as it helps to indicate major signals on the trading charts. Here is how the %K line looks:
%K = 100[(C-L5close)/ (H5-L5)
Where C represents the most recent closing price, L5 represents the low five previous trading sessions and H5 represents the highest price traded within a 5 day period.
The %D line formula is represented this way:
%D=100 X (H3/L3)
How to read the Stochastic Oscillator on a chart
As mentioned above, the chart will have two lines – K and D lines. As a trader, it is important to know that the K line is the fastest while the D line is the slowest. To trade with the Stochastic Oscillator, a trader or investor must watch the D line as well as the price of the security as it changes towards overbought or oversold positions.
When the price moves above the overbought position (above 80 level), an investor should begin considering selling off the stock but when it’s below the oversold position (below 20 level), not only should the investor buy but he or she should move up with increased volume.
Why it matters
What savvy investors have noted is that observing the Stochastic Oscillator especially when it comes to overbought or oversold positions helps to determine when an investor or trader can enter or exit a trade.
This is because it’s designed to smooth price moves and allow analysts to monitor the underlying trend of the market. Focusing on trends helps investors or traders make better trading decisions.
It is important to note that there are problems that may arise as a result of using the Stochastic Oscillator resulting in the loss of several trades. To improve one’s probability of winning trades, it is advisable to watch the oversold and overbought positions.
By now you already know that the Stochastic Oscillator is utilized in different scenarios for example determining overbought and oversold positions, divergences, bull and bear trade set-ups. Furthermore, it allows investors and traders to know when to enter and exit a trade. When used with other indicators, it can help to filter out false signals.
As a result, it’s considered as one of the best trading tool for investors and traders.