Stochastic Oscillator

You can change these parameters in the “Style” tab of the indicator’s settings. If both the main and signal curves (the green and red lines on the chart above) are above the zero line (blue), the market is overbought; if below, the market is oversold. This way the user can always have a better understanding of the overbought and oversold levels of the market. The premise of a Stochastic Oscillator is that the closing price stays at the previous local maximums for a while in the bullish trend and stops at the level of prior minimums in a bearish trend. The stochastic oscillator and the relative strength index (RSI) are both price momentum tools used to predict market trends. While often used in tandem, there are notable differences between the two indicators.

  • Trade signals are generated when the “fast” %K line crosses above or below the three-period moving average, or “slow” %D.
  • Whenever you’re acting on a signal from the stochastic indicator, always confirm with another technical analysis indicator.
  • Lane noted that the Stochastic Oscillator indicates the momentum of a security’s price movement.
  • Meanwhile, the RSI tracks overbought and oversold levels by measuring the velocity of price movements.
  • Based on the text above, you can recognize the bearish divergence from a bullish divergence, in the overbought or oversold region.
  • The main shortcoming of the oscillator is its tendency to generate false signals.

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There is some debate as to the origins of the stochastic oscillator. However, George C. Lane is perhaps more commonly credited for his role in popularizing it. Traders need to understand where the stochastic oscillator acts best and where its short-comings are, to get the most out of the indicator.

Stochastic Oscillator

This scan starts with stocks that are trading above their 200-day moving average to focus on those that are in a bigger uptrend. Of these, the scan then looks for stocks with a Stochastic Oscillator that turned up from an oversold level (below 20). This is why it is important to confirm the trading signals with indications from other technical indicators such as the relative strength index (RSI). A divergence occurs when momentum is going in one direction and the price in another. Should the stochastic oscillator fail to confirm momentum is going in the same direction as the price, this means that the trend may be about to reverse.

What Does %K Represent on the Stochastic Oscillator?

%K displays the closing price in relation to the specified time interval, and %D is the classic MA. It was created in the 1950-s by George Lane, a famous trader and economist. When developing the indicator, he laid the basis for Momentum, that is, how much the price amplitude changes.

The solid black line in the image below is called the %K and is determined by a specific formula (explained later in the article), while the red dotted line is a 3-period moving average of the %K line. The stochastic oscillator is a useful indicator when it comes to assessing momentum or trend strength. The stochastic oscillator, and oscillators in general, are presented in an easy to understand manner with clear buy and sell signals. However, an overreliance on these signals, without a deeper understanding of stochastic oscillators, is likely to end in frustration. The stochastic indicator establishes a range with values indexed between 0 and 100.

How to use the stochastic oscillator: trading strategies

A longer look-back period (20 days versus 14) and longer moving averages for smoothing (5 versus 3) produce a less sensitive oscillator with fewer signals. Yahoo was trading between 14 and 18 from July 2009 until April 2010. Such trading ranges are well suited for the Stochastic Oscillator.

Stochastic Oscillator

When this happens, a sell signal is generated once the oscillator reading returns below 80. The and relative strength index (RSI) are both price momentum tools used to forecast price trends in the market. The period is set to 14 so that there is a large enough data sample to give a meaningful calculation but short enough so that it’s responsive to changes. You can modify the lookback period on your trading platform to adjust the stochastic oscillator’s responsiveness. Similarly, a bullish divergence occurs when the market price makes a new low but the oscillator does not follow suit by moving to a new low reading.

Moving Averages: How to Use EMA Indicator Guide

You will find that where there is a strong uptrend, which hasn’t been broken, at some point, there will be a pullback which can be an opportunity to buy on weakness. This is why the fast stochastic oscillator is more appropriate for short-term/day traders. Lane noted that the Stochastic Oscillator indicates the momentum of a security’s price movement. It is not a trend indicator for price as, for example, a moving average indicator is. The oscillator compares the position of a security’s closing price relative to the high and low (max and min) of its price range during a specified period of time. In addition to gauging the strength of price movement, the oscillator can also be used to predict market reversal turning points.