Stochastic Oscillator: Ways it Can be Used in Trading

Technical analysis is often the bread and butter of short-term traders because specialized trading tools can quickly analyze price data and trends. While long-term investors are usually more concerned with fundamentals like profit growth and margins, short-term traders typically can’t wait for quarterly earnings reports to enter and exit positions.  One of the most commonly used tools is the stochastic oscillator, which can be used to identify entry and exit points through changes in trend or momentum.

What Is the Stochastic Oscillator?

Like many technical tools, the stochastic oscillator is a momentum indicator designed to send signals to traders before the price action can follow. Designed by securities analyst George Lane, this oscillator compares the current price of an asset to a price range from a particular time period to gauge the strength (or weakness) of a particular trend.

Short-term traders using technical analysis look for signals that momentum is either strong, weak or about to reverse course. The stochastic oscillator combines two variables: %K (the fast stochastic) and %D (the slow stochastic). These two percentages work in unison to create buy or sell signals from a single range-bound indicator.

How Does the Stochastic Oscillator Work?

Before laying out the formula, you must select a time frame for the highs and lows. 14 trading sessions is the standard timeline used in most calculations, but you can lengthen or shorten this for your own purposes. 

Calculating the stochastic oscillator means finding two variables: %K and %D. The first number you want to find is %K, which requires the following formula: 

• %K = (Latest Close - Lowest Price) / (Highest Price - Lowest Price) x 100 

Next, you’ll need to calculate %D, which is the three-day moving average of the %K Again, the two percentages should closely track each other, with crossovers often providing trading signals. 

How to Read and Interpret the Stochastic Oscillator

The oscillator usually appears in the bottom section of the stock chart and measures from 0 to 100. Signals tend to occur when the oscillator rises above 80 or drops below 20. Readings over 80 indicate that the security being charted may be overbought, while readings under 20 usually signal an oversold asset.

Additionally, the K line and D line can create signals when a crossover event happens. No, this isn’t when your two favorite TV shows combine casts for an episode; this is when bearish or bullish signals are sent based on the fast and slow stochastics crossing paths. More on this scenario will be fleshed out below.

Possible Uses of the Stochastic Oscillator 

Interested in using this tool in your trading strategy? Here are four techniques where the stochastic oscillator could be effective:

1. Stochastic Overbought/Oversold Strategy

The simplest technique is to monitor the ranges of the oscillator to predict overbought or oversold conditions. For example, if a stock you’re monitoring sees the oscillator trend over 80, it could mean the price is overextended and a period of consolidation (or a downtrend) may be upcoming.

2. Stochastic Divergence Strategy

Sometimes the stochastic oscillator will begin to ascend or descend while the asset price continues in its current direction. This is known as divergence, and it could signal that the momentum of the current uptrend or downtrend is weakening.

3. Stochastic Crossover

When the fast stochastic (%K) crosses below the slow stochastic (%D) in the overbought range, this is typically considered a sell signal. Conversely, when the %K moves above the %D in the oversold region, this is viewed as a buy signal.

4. Stochastic Bull/Bear Strategy

The stochastic oscillator will often show when momentum in a current trend is increasing or decreasing. For example, if an asset in an uptrend appears to have gotten stuck in a range but the oscillator shows momentum increasing, this is a bullish signal. Bearish signals occur when this movement happens in the other direction. Remember, the stochastic oscillator measures the strength of the price action, not the volume or volatility of the asset.

Example of the Stochastic Oscillator

Imagine you’re investigating a range-bound stock. The price action has fluctuated between $10 and $15 for the last two weeks, and you aren’t sure whether a breakout to the upside is going to occur. 

Here’s where technical analysis comes in handy. If the stochastic oscillator continues moving upward despite a flat stock price, its a signal that momentum is building and it could be a good time to buy before the price range is broken to the upside.

Possible Advantages of Using the Stochastic Oscillator

Here are a few of the benefits investors can reap using the stochastic oscillator:

• Find oversold or overbought stocks: Finding stocks that are about to have a trend reversal is one of the primary focuses of short-term traders. The stochastic oscillator sends signals that stocks may be about to reverse course, allowing traders to enter positions before the price action follows.
• Identify trend strengths: Volatile prices don’t always indicate a trend continuation or reversal. The stochastic oscillator is ideal for measuring the strength of a trend, which provides useful information on whether the price action is justified.
• Simple formula to understand: Traders appreciate simplicity. The stochastic oscillator’s variables are easily interpreted and clear signal zones appear above  the 80 and below the 20 ranges of the chart.

Limitations of Using Stochastic Oscillator

Investors should also be aware of the drawbacks presented by momentum indicators like the stochastic oscillator:

• Backward looking: In markets, past performance is no guarantee of future performance. And the data going into the stochastic oscillator consists of prices that occurred in the past.
• Propensity for false signals: Momentum can be tricky, and the oscillator frequently sends buy and sell signals that don’t come to fruition. Multiple tools should be used to lessen the frequency of false trading signals.

The Stochastic Oscillator Measures Trend Strength But Can Also Send False Signals

If you use technical analysis in your trades, it’s likely the stochastic oscillator is in your toolbox. But no indicator is perfect, and while this one provides easy-to-interpret signals, these must be measured with other tools to avoid false signals. Just because the stochastic oscillator reads 80 doesn’t mean a particular stock is overbought. Be sure to use a variety of trading tools to make the most of your buying and selling opportunities.

Frequently Asked Questions