Developed by George Lane in the late 1950s, the stochastic oscillator is a technical analysis tool that has become a staple for short-term traders. The tool is a momentum oscillator, which measures price changes over time to tell you the momentum of a move. High momentum trends are likely to continue, and decreasing momentum points to a reversal on the horizon .
The stochastic oscillator generates buy and sell signals based on patterns in price movements and a historic reaction to those patterns.
But what exactly is the stochastic oscillator, and how can you use it to become a more successful trader?
What Is the Stochastic Oscillator?
The stochastic oscillator is a technical indicator that compares the most recent closing price of a financial asset to a high-low range of prices over a period of time, generally 14 days. This comparison helps to determine if the asset is experiencing overbought or oversold conditions.
At its core, the tool is a momentum indicator, pointing to both the direction and vigor of price movements. The general idea is that if the asset is trending up, the current price will be closer to the highest high for the period, generating a high reading; when it’s trending down, the current price will be closer to the lowest low, generating a low reading.
Moreover, Lane theorized that momentum changes before price changes, meaning that signals from this momentum oscillator should happen prior to major price movements. It’s used to determine the strength of current trends, find trend reversals, and help determine the best time to buy and sell assets.
How to Calculate the Stochastic Oscillator
This indicator is popular among traders and is widely available on most trading charts. So, there’s a strong chance you’ll never have to calculate the oscillator readings on your own. Nonetheless, it’s best to know the inner workings of the tools you use.
In most cases, the stochastic oscillator uses a 14-day time frame, but you can adjust the time frame to fit your needs.
Here’s how to calculate this indicator:
Stochastic Oscillator Formula
The formula for the stochastic oscillator is as follows:
((C – LP) ÷ (HP – LP)) x 100 = K
The following key applies when using the formula above:
- C – Most recent closing price
- LP – Lowest price in the data set
- HP – Highest price in the data set
- K – Oscillator reading
Traders who use the stochastic oscillator use two trendlines. The K-line is a plot of the readings of the oscillator, also known as the fast stochastic or the signal line. The D-line, or slow oscillator, is the three-day simple moving average (SMA) of the oscillator’s reading.
Signals are generated based on the reading of the oscillator and crossovers between the signal line and the D-line.
Let’s say ABC stock closed at $100 today. Over the past 14 days, the stock has traded between a low of $95 and a high of $109. The formula to determine the oscillator reading for this example is:
(($100 – $95) ÷ ($109 – $95)) x 100 = 35.71
How to Read the Stochastic Oscillator
Assets are considered overbought when the oscillator reading is 80 or above and oversold when the reading is 20 or below. Overbought assets may have unjustifiably high prices and can be due for a pullback, whereas oversold assets may be priced below their true value and ripe for a rebound.
The oscillator is range-bound, meaning that its reading will always fall between zero and 100. Traders read the indicator at a glance, knowing the closer the number is to zero, the more oversold it is, and the closer it is to 100, the more overbought it is.
Traders also read the indicator by plotting two trendlines on the financial asset’s chart: the signal line (oscillator reading) and the D-line (three-day SMA of the oscillator). Traders then analyze the relationship between the two lines to determine buy and sell signals.
Trading Strategies Using the Stochastic Indicator
Traders commonly use three strategies when employing the stochastic indicator in their trading plan. Those strategies include:
The overbought/oversold strategy is the most simple strategy to follow using this indicator. All you’ll need to do is look at the reading with the following in mind:
- 80 or Above: Sell Signal. Stochastic readings at 80 or above suggest the asset being analyzed is overbought, which means the price is likely nearing resistance and a bearish reversal may be on the horizon.
- 20 or Below: Buy Signal. Stochastic readings of 20 or below suggest the asset being analyzed is at oversold levels. This means the price of the asset is nearing support and a bullish reversal may be coming.
When using the overbought/oversold strategy, the signals are most accurate when both the fast and slow readings of the oscillator are above 80 or below 20.
Let’s look at Apple’s stock chart with stochastics from the beginning of April 2022 (below). The oscillator appears as a sub-chart below the main stock chart:
In the stochastics chart at the bottom of the image, the signal line is represented in black and the baseline is red. Both readings in this chart are over 80, suggesting the stock is overbought and likely to make a bearish reversal.
Stochastic Crossover Strategy
The stochastic crossover strategy is a bit more involved than the overbought/oversold strategy, but it’s a great way to verify signals from the other stochastic strategies. The crossover strategy uses both the K-line and the D-line plotted on a financial asset’s chart.
Once the lines are plotted, traders look for crossovers, or points where the faster-moving K-line crosses over the slower-moving D-line. When the crossover is in the upward direction, it acts as a buy signal, suggesting recent prices are increasing. When the crossover is in the downward direction, it acts as a sell signal, suggesting recent prices are decreasing.
Let’s look again at Apple’s chart, with the sub-chart below the main chart showing the red and black lines plotting the stochastic oscillator:
Note that the fast Stochastic (K) is plotted in black and the slow stochastic (D) is plotted in red. Each time the black line crosses above the red line, it acts as a buy signal, suggesting prices are likely to head up moving forward. When the black line crosses below the red line, it’s a sell signal, suggesting Apple’s stock will fall ahead.
Stochastic Bull/Bear Strategy
The bull/bear strategy uses the divergence between price action and the movement of the stochastic oscillator to determine when reversals might take place.
For example, if a stock is trending down and mints a new low, but the stochastic oscillator reads a higher low, the divergence could mean the downtrend is coming to an end and the bulls will take control soon. This is known as a bullish divergence.
On the other hand, when a price is on the uptrend and hits new highs, but the stochastic oscillator produces a lower high, a bearish divergence is taking place, suggesting declines could be ahead.
The Relative Strength Index (RSI) vs. the Stochastic Oscillator
The relative strength index (RSI) and stochastic oscillator are both momentum oscillators, made to generate the same types of signals. The difference is the underlying data and methodology the two use.
The stochastic oscillator is based on the relationship between the most recent closing price and the recent range of prices.
The RSI, by contrast, measures the velocity (or speed) of price movements rather than the relationship between recent prices and the closing price of an asset.
Because these indicators are based on different points of data, they are often used in conjunction with one another before a trade is made, each helping to verify the signals of the other.
Stochastic Oscillator Limitations
As a technical indicator, the stochastic oscillator has proven its worth time and time again, but it’s not perfect. The biggest limitation to the indicator is the potential for false signals, where the indicator suggests a move is coming that doesn’t come to fruition.
Due to the potential for false signals, it’s important to use the stochastic indicator in conjunction with other technical indicators when making your trades.
Stochastic Oscillator FAQs
Technical indicators are complex topics that often lead to questions. Some of the most common questions surrounding the stochastic oscillator are answered below:
What Do K and D Mean?
K is the reading for the oscillator that acts as the signal line when plotted on a trading chart. D is the abbreviation used to describe a three-day moving average of K. Traders plot both K and D on trading charts and analyze the relationship between the two trendlines to generate buy and sell signals.
What Is a Slow Stochastic Oscillator?
The slow stochastic oscillator is known as the D-line and is another term for the three-day moving average of the oscillator’s reading. The slow stochastic is used for two reasons:
- Generate Signals. The K-trendline crossing above or below the D-trendline generates buy or sell signals.
- Verify Signals. Traders using the overbought/oversold strategy focus primarily on the K-reading in the oscillator. But they can also use the slow stochastic (D-line) to verify whether the asset is in overbought or oversold territory because it moves more slowly than the fast stochastic (K-line).
What Are the Two Lines in the Stochastic RSI?
The Stochastic RSI, or StochRSI, applies the formula for the stochastic oscillator to RSI data, combining the two methods to determine the strength of a trend. As with the traditional stochastic oscillator, the two most-used trend lines in the Stochastic RSI are K (the signal line) and D (the baseline).
The stochastic oscillator has become one of the most widely used technical analysis tools in financial markets. Whether you’re trading stocks, forex, cryptocurrency, or any other asset, paying attention to the stochastic reading and crossovers has the potential to generate compelling buy and sell signals.
However, like any other financial tool, the oscillator isn’t perfect. Traders should consider using it in conjunction with other technical indicators when researching opportunities.