Stochastic Oscillator PDF

Stochastic Oscillator
A stochastic oscillator is a momentum indicator comparing a particular closing price of a security to

a range of its prices over a certain period of time. The sensitivity of the oscillator to market
movements is reducible by adjusting that time period or by taking a moving average of the result.
It is used to generate overbought and oversold trading signals, utilizing a 0-100 bounded range of
values.
KEY TAKEAWAYS
• A stochastic oscillator is a popular technical indicator for generating overbought and
oversold signals.
• It is a popular momentum indicator, first developed in the 1950s.
• Stochastic oscillators tend to vary around some mean price level, since they rely on an
asset's price history.
The Formula For The Stochastic Oscillator Is
%K=(H14−L14C−L14 )×100
where:
C = The most recent closing price
L14 = The lowest price traded of the 14 previous trading sessions
H14 = The highest price traded during the same 14-day period
%K = The current value of the stochastic indicator
%K is referred to sometimes as the slow stochastic indicator. The "fast" stochastic indicator is
taken as %D = 3-period moving average of %K.
The general theory serving as the foundation for this indicator is that in a market trending upward,
prices will close near the high, and in a market trending downward, prices close near the low.
Transaction signals are created when the %K crosses through a three-period moving average,
which is called the %D.
What Does The Stochastic Oscillator Tell You?
The stochastic oscillator is range-bound, meaning it is always between 0 and 100. This makes it a
useful indicator of overbought and oversold conditions. Traditionally, readings over 80 are
considered in the overbought range, and readings under 20 are considered oversold. However,
these are not always indicative of impending reversal; very strong trends can maintain overbought
or oversold conditions for an extended period. Instead, traders should look to changes in the
stochastic oscillator for clues about future trend shifts.
Stochastic oscillator charting generally consists of two lines: one reflecting the actual value of the
oscillator for each session, and one reflecting its three-day simple moving average. Because price is
thought to follow momentum, intersection of these two lines is considered to be a signal that a
reversal may be in the works, as it indicates a large shift in momentum from day to day.
Divergence between the stochastic oscillator and trending price action is also seen as an important
reversal signal. For example, when a bearish trend reaches a new lower low, but the oscillator
prints a higher low, it may be an indicator that bears are exhausting their momentum and a bullish
reversal is brewing.
A Brief History
The stochastic oscillator was developed in the late 1950s by George Lane. As designed by Lane, the
stochastic oscillator presents the location of the closing price of a stock in relation to the high and
low range of the price of a stock over a period of time, typically a 14-day period. Lane, over the
course of numerous interviews, has said that the stochastic oscillator does not follow price or
volume or anything similar. He indicates that the oscillator follows the speed or momentum of
price. Lane also reveals in interviews that, as a rule, the momentum or speed of the price of a stock
changes before the price changes itself. In this way, the stochastic oscillator can be used to
foreshadow reversals when the indicator reveals bullish or bearish divergences. This signal is the
first, and arguably the most important, trading signal Lane identified.
Example Of How To Use The Stochastic Oscillator
The stochastic oscillator is included in most charting tools and can be easily employed in practice.
The standard time period used is 14 days, though this can be adjusted to meet specific analytical
needs. The stochastic oscillator is calculated by subtracting the low for the period from the current
closing price, dividing by the total range for the period and multiplying by 100. As a hypothetical
example, if the 14-day high is $150, the low is $125 and the current close is $145, then the reading
for the current session would be: (145-125)/(150-125)*100, or 80.
By comparing current price to the range over time, the stochastic oscillator reflects the consistency
with which price closes near its recent high or low. A reading of 80 would indicate that the asset is
on the verge of being overbought.
The Difference Between The Relative Strength Index (RSI) and The Stochastic Oscillator
The relative strength index (RSI) and stochastic oscillator are both price momentum oscillators that
are widely used in technical analysis. While often used in tandem, they each have different
underlying theories and methods. The stochastic oscillator is predicated on the assumption that
closing prices should close near the same direction as the current trend. Meanwhile, the RSI tracks
overbought and oversold levels by measuring the velocity of price movements. In other words, the
RSI was designed to measure the speed of price movements, while the stochastic oscillator
formula works best in consistent trading ranges.
In general, the RSI is more useful during trending markets, and stochastics more so in sideways or
choppy markets.
Limitations Of The Stochastic Oscillator
The primary limitation of the stochastic oscillator is that it has been known to produce false
signals. This is when a trading signal is generated by the indicator, yet the price does not actually
follow through, which can end up as a losing trade. During volatile market conditions this can
happen quite regularly. One way to help with this is to take the price trend as a filter, where
signals are only taken if they are in the same direction as the trend.

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What is a stochastic oscillator and what does it measure?

What are some differences between the stochastic oscillator and the relative strength index (RSI)?

Stochastic Oscillator

A stochastic oscillator is a momentum indicator comparing a particular closing price of a security to

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