What is the Stochastic Oscillator?
The Stochastic Oscillator is an indicator that compares the most recent closing price of a security with the highest and lowest prices of a specified time period. It provides a reading that moves (oscillates) between zero and 100, indicating a security’s momentum.
A stochastic measure is essentially a percentage representation of a security’s trading range over a specified time period. (The default setting for the Stochastic Oscillator is 14 periods (hourly, daily, etc.). A reading of 0 represents the lowest point of the trading range. A reading of 100 represents the highest point during the specified period. indicates
Stochastic Oscillator Formula
The formula for the Stochastic Oscillator is:
%k = (Last Close Price – Lowest Price)/(Highest Price – Lowest Price) x 100
%D = 3-day SMA of %K
Where:
- C is the last closing price
- The lowest price is the lowest price for the period.
- Highest High is the highest value for that period.
Oscillator history
Dr. George Lane developed the Stochastic Oscillator for use in technical analysis of securities in the late 1950s. Financial analyst Lane was one of the first researchers to publish a research paper on the use of probability theory. He believed that this indicator could be used profitably in combination with Fibonacci retracement cycles or Elliott Wave theory.
Lane pointed out that the Stochastic Oscillator indicates the momentum of a security’s price movement. For example, this is not a price trend indicator like the moving average indicator is. The oscillator compares the position of a security’s closing price over a specified time period with the highs and lows (highs and lows) of its price range. In addition to measuring the strength of price movements, oscillators can also be used to predict market reversal tipping points.
Using the Stochastic Oscillator
The main uses of stochastic oscillators are:
Identify overbought and oversold levels
An overbought level is indicated when the probabilistic reading exceeds 80. A reading below 20 indicates an oversold condition in the market. A sell signal is generated when the oscillator reading crosses the 80 level and then returns to below 80. Conversely, when the oscillator breaks below 20 and rises above 20, it gives a buy signal. Approaching the upper or lower limit of the trading range for the specified period, respectively.
Divergence
Divergences occur when the security price forms new highs or lows that are not reflected in the stochastic. For example, the price moves to new highs, but the oscillator does not correspondingly move to new highs. This is an example of a bearish divergence and could indicate an imminent market reversal from an uptrend to a downtrend. The failure of the oscillator to reach new highs in line with price action indicates that the uptrend momentum is starting to wane.
Similarly, a bullish divergence occurs when the market price makes a new low but the oscillator does not follow suit by moving to the new low reading. indicates that there is a possibility that
It is important to note that the Stochastic Oscillator can emit divergence signals before price action changes direction. For example, if the oscillator signals a bearish divergence, the price may continue to rise for several trading sessions before turning downward. This is why we recommend that lanes wait for confirmation of a market reversal before entering a trading position. Trading should not be based solely on divergence.
crossover
Crossovers are points where the fast and slow probability lines intersect. The fast probability line is the 0%K line and the slow probability line is the %D line. If the %K line crosses and rises above the %D line, this is a bullish scenario. Conversely, when the %K line crosses the %D Stochastic line from top to bottom, it indicates a bearish sell signal.
Limitations of the Stochastic Oscillator
The main drawback of oscillators is their tendency to generate erroneous signals. They are especially common in turbulent and highly volatile trading conditions. This is why the importance of confirming trading signals from the Stochastic Oscillator with indicators from other technical indicators is emphasized.
Traders should always keep in mind that oscillators are primarily designed to measure the strength and weakness of price action movements in the market, not the trend or direction.
Some traders use the oscillator’s more extreme readings to indicate overbought/oversold conditions in the market, thereby reducing the tendency of the Stochastic Oscillator to generate false trading signals. We aim to Instead of using numbers above 80 as a borderline, interpret only numbers above 85 as indicative of overbought conditions. On the bearish side, only readings below 15 are interpreted as indicating oversold conditions.
An adjustment to 85/15 will reduce the number of false signals, but it may cause traders to miss some trading opportunities. For example, if the oscillator reaches a high of 82 during an uptrend and the price then falls, the trader may have missed the opportunity to sell at the ideal price because the oscillator did not reach the required overbought indicator level. there is. 85 and above.
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A final word about oscillators
The Stochastic Oscillator is a popular and widely used momentum indicator. Traders often use diverging signals from oscillators to identify market reversal points. However, oscillators tend to generate erroneous signals. Therefore, it is best used in conjunction with other technical indicators rather than as a sole source of trading signals.