Stochastic Oscillator

What Is a Stochastic Oscillator?

A stochastic oscillator is a momentum indicator used in trading to determine entry and exit points based on whether a financial instrument is overbought or oversold.

Dr. George Lane developed the concept of stochastics in the 1950s, which involves comparing the current price to a price range over a specific period.

Tracking Momentum with Price Range

The stochastic oscillator displays the position of a stock’s closing price relative to its high and low range, typically over 14 days.

According to Lane, the oscillator does not change price, volume, or other factors but tracks the price’s pace or momentum.

The graph of a stochastic oscillator usually consists of two lines

  • The K line represents the oscillator’s actual value for each period.
  • The D line reflects the three-day simple moving average.

The crossing of these two lines indicates an imminent reversal, as it signifies a significant change in momentum on a day-to-day basis.

Why Is the Stochastic Indicator Used?

The stochastic indicator is used to gauge ongoing market sentiment.

It provides values between 0 and 100, with readings closer to 0 suggesting a bearish condition and readings closer to 100 indicating a bullish state.

Unlike some other indicators, the stochastic oscillator does not show negative readings or values greater than 100.

Stochastic Oscillator Thresholds and Divergences

Traders commonly use the thresholds of 20 and 80. Readings below 20 indicate an oversold market, while readings above 80 suggest an overbought market.

It’s important to note that even when the indicator reaches values significantly above or below 80 and 20, it can still indicate overbought or oversold conditions but may not necessarily imply a reversal.

Divergences occur when the stochastic oscillator fails to establish a new price high or low.

A bullish divergence occurs when the price makes a lower low while the oscillator produces a higher low, indicating a decrease in negative momentum.

This may signal a potential reversal.

Conversely, a bearish divergence occurs when the price makes a higher high while the oscillator makes a lower high.