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How to Use A Stochastic Oscillator

A stochastic oscillator is a handy tool that has been used in the investing world for more than six decades. It is most useful for technical analysis of market conditions to support momentum investing. As a type of momentum oscillator, the stochastic oscillator uses a simple, range-bound calculation for determining overbought and oversold signals. Developed in the late 1950s by technical analyst George Lane, a stochastic oscillator has become an essential instrument for determining trend lines and tracking price moves among stocks.

A stochastic oscillator is a momentum indicator that calculates the divergence between a stock’s current price or closing price and its price range over a pre-determined period. This output can then be translated into buy signals or sell signals, giving investors insight into the likely movements of an asset.

How to Calculate a Stochastic Oscillator

The formula for a stochastic oscillator may look complicated, but it’s not all that bad.

%K = (C − L14 / H14 − L14) × 100

The variables are defined as:

C = The most recent closing price

L14 = The lowest price traded of the 14 most recent trading sessions

H14 = The highest price traded during the same 14-day period

%K = The current value of the stochastic indicator, range-bound by 100

A higher value of %K, such as 80 and up, generally indicates that the asset is overbought, while scores under 20 are oversold. However, neither guarantees anything about the stock's future price, just that it might be more or less likely for an uptrend or downtrend.

This classic %K measurement is often known as the fast stochastic indicator. Slow stochastic indicators refer to a “stabilized” or controlled 3-period moving average of %K. A slow stochastic indicator is also called a D-Line or %D.

How the Indicator Measures Momentum

The stochastic oscillator compares the current closing price of a stock to its trading range of prices over time, which allows it to describe the consistency with which it closes near recent highs and lows. In other words, the process looks at how often a stock’s current price has been close to its highest high in a given period. Likewise, it gives you the same information about how frequently a stock has been close to its lowest low in a given time frame. Using this high-low range can give you a lot of information.

How to Read a Stochastic Oscillator

The key to accurately reading a stochastic oscillator chart is to compare the stochastic oscillator reading with the three-day simple moving average of %K.  A divergence between %K and %D may demonstrate that the actual or future trend may be contrary to the current trend. The oscillator can help investors correct their assumptions about how bullish or bearish a new higher high or lowest low might actually be.

The oscillator reading for any given time period is between 0 and 100. Anything above 80 is considered the top of the range, while below 20 is considered the bottom.

Stochastic oscillator compared to RSI

The stochastic oscillator is one of many popular technical indicators used to evaluate an asset's momentum. RSI, or Relative Strength Index, is another important momentum indicator.

RSI considers the speed and magnitude of an asset’s price changes to determine if the stock is overvalued or undervalued.

While RSI primarily tracks oversold and overbought conditions through a pure measurement of price movement, price actions, and velocity, the stochastic oscillator does something different.

The stochastic oscillator operates on the premise that close prices of stocks are an accurate reflection of their overall trend. In general, a stochastic oscillator is a more helpful indicator for markets with low resistance levels and a high rate of unexpected pullbacks. Stochastic oscillators usually do best in markets that see a lot of trend reversals or are otherwise more unpredictable. RSI is often better used in markets with simpler trends and signal lines.

Given the complexity of calculating, monitoring, and trading, RSI and stochastic indicators are rarely used by beginner investors. These indicators are used mainly by professional technical analysts or retail investors with the right technology to support their trading.

Limitations of a Stochastic Oscillator

Like all other momentum indicators, a stochastic oscillator shouldn’t be used in a vacuum. While stochastic lines can indicate oversold levels or unnoticed bearish divergence in a given stock, they can also produce false signals. False signals are simply events that the stochastic oscillator incorrectly predicted.

While this happens will all momentum-based tools, it’s important to note. A crossover of the d-line and stochastic line represents a possible future change but does not mean it will come to pass.

Benefits of the Stochastic Oscillator

Stochastic oscillators are great for specific applications and are relatively easy to understand once you’ve got the basics and the math down. They’re available on some investing platforms with easy-to-read visual lines.

Composer is a leading investment platform for momentum investing. Composer offers technical analysis tools like momentum indicators to give you insights into price trends. In addition, Composer allows investors to backtest custom-built momentum trading strategies and automate the portfolio management of the strategy if they choose to invest. Learn more at composer.trade.

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