A stochastic oscillator is an oscillator momentum indicator and is one of the commonly used tools in intraday. Read on to learn more about the indicator and see how you can form trading strategies using information from them.
Momentum indicators are a few of the most used technical analysis tools for trading signals. They measure the strength of price or price trend to gauge the potential of investing in a stock. Oscillator momentum indicators make the job a little bit easy as they usually show reading between pre-set numbers (usually 0-100).
What is a stochastic oscillator?
Stochastic is a momentum indicating, oscillating indicator. The indicator works similarly to the famous Relative Strength Index and is often compared and sometimes used alongside it. But stochastic oscillator arguably gives more comprehensive information.
The stochastic oscillator is one of the oldest technical analysis tools out there. It is developed in the early 1950s by the famous trader and technical analysis expert George Lane. The indicator has seen several changes to how it works since then. The older version of the indicator was replaced by a newer version to get better readings from the same.
George Lane believed that the indicator doesn’t follow volume or price; instead, it follows the speed of the momentum. He says that, as a rule of thumb, the price tends to follow the momentum, enabling traders to predict price movements. Due to the same reason, the stochastic oscillator is also a leading indicator.
Similar to RSI, the stochastic oscillator also oscillates between zero and 100. The reading is in percentage here. A higher level indicates more buying interest, whereas a lower level indicates higher selling interest. The threshold levels are 80 and 20. If the indicator touches or breaches these levels, it indicates high overbought and oversold levels, and a trend reversal could follow.
The stochastic oscillator measures overbought and oversold levels quite differently from RSI’s. It takes the last closing price and compares it with the highs and lows of a pre-set time frame compared with the current price.
The indicator has two lines – %K line and %D line. %K is the faster line, whereas %D is slower. The former compares the latest closing price with a set of previous highs and lows while %D is a three-period moving average of %K line. The indicator works best when the market doesn’t show clear trends (choppy markets). The current value of the indicator and the crossover of the lines provide important information regarding price movements.
The formula for stochastic oscillator indicator
Most charts now have an updated version of a stochastic oscillator which you can add to your chart with a click of a button. But knowing how it is calculated helps you understand how it works. Below is a formula for the same. As said above, there are two lines in the Stochastic oscillator.
The K line (stochastic line) can be found using the below formula –
%K = 100 x (CP – L14) / (H14 – L14)
CP = the most recent closing price
L14 = the lowest trading price of the asset in the previous 14 trading sessions
H14 = the highest trading price of the asset in the previous 14 trading sessions
The formula of %D line is –
D = 100 x (H3/L3)
H3 = the highest trading price of the asset in the previous three trading sessions
L3 = the lowest trading price of the asset in the previous three trading sessions
Stochastic oscillator in a chart
Let us now see what a stochastic oscillator will look like in a graph.
Here, you can see stochastic lines in the graph below the price chart. There are two lines here, as we have discussed above. Here, the black line is the fast line, and the black is the slow line. As evident from the chart, both lines follow a path that is almost similar.
In the chart, there are two indications on points 20 and 80, marking oversold and overbought conditions, respectively.
Technical analysis using stochastic oscillators
The most basic purpose of a stochastic indicator is to identify overbought and oversold levels. As seen above, a stochastic line reading above 80 shows high levels of overbuying. This is indicative of the fact that there could be a trend reversal. But how do we make the best out of this information? Take a low at the below picture.
Here, you can see that the price has gone down once the indicator shows oversold levels. Hence, the same can be considered a sell signal. You could either sell your current holdings or enter a long position, according to your strategy.
Similarly, a stochastic oscillator can be used to identify oversold conditions as well. Let us look at another chart to understand this better.
Unlike the above scenario, the two lines went below the 20-level mark. This indicates highly oversold conditions. Hence, you can expect the trend to reverse soon once the threshold has been reached.
Proving the indicator right, the very next candle lights up green. Although a tries to create a roadblock for the new trend, it was proven to be in vain, and a bigger green candle took over, putting the price in bullish territory.
Stochastic oscillator strategies
Even though the primary indication that the oscillator gives is regarding overbought and oversold levels, the indicator gives much more information which can be used to formulate trading strategies. Let us see how.
A divergence occurs when the price movement completely disagrees with the indicator. According to where the divergence is formed, it can either be a bullish divergence or a bearish divergence. Let us take the case of a bullish divergence first.
Here, the price and the stochastic oscillator have to show a different signal. A bullish divergence occurs when the price sets a low that is lower than the previous low, but the stochastic indicator shows a low higher than its previous low. This indicates that there is lesser momentum downwards. The stochastic line breaking the middle ground (level 50) from above, after forming the higher low, can be used as an entry point or confirmation for the trend reversal.
Such a situation is usually followed by a highly bullish time period. Below is a pictorial representation of a bullish divergence.
A divergence like the above is usually a clear buy signal. You could buy the stocks to earn from the rise or enter a long position, according to your trading strategy, to make the best out of this information. Either way, setting a stop-loss can help you avoid losses if the signal turns out false.
A bearish divergence forms in the stochastic oscillator when the stock price forms a higher high than the previous high, while the indicator forms a high lower than the previous high. Here, too, the point where the stochastic oscillator line breaks the 50-level mark after forming the divergence could be used as a confirmation or entry point. This divergence usually results in the stock price going down considerably. Take a look at the picture below to understand this better.
Such a divergence gives you a clear sell signal. You can either sell the shares or enter a short position according to your trading goals. If you decide to go against the reading due to any reason, including because of an opposite reading from another indicator, setting a stop-loss at the level where the divergence occurs can help you limit your loss if your call turns out to be wrong.
Bull and bear set-ups
The divergences in the stochastic indicator may also predict the bottoms and tops. This is called bear or bull set-up. Usually, when the indicator reaches a top or bottom, it is preceded by the price.
The above is what a bull setup would like. It happens when the stock price forms a lower high than the previous high when the stochastic oscillator touches a high, which is higher than the previous high. The idea here is that since the indicator touches a high, the asset will soon follow suit, and traders can be ready to take action. Now, take a look at the below picture.
This is what a bear setup looks like. It occurs when the stock price forms a low, which is higher than the previous low, but the stochastic oscillator line forms a lower low. Here, too, the idea is that the price will follow the indicator’s movement soon.
Finding entry points
The most basic function of the stochastic oscillator is to find overbought or oversold regions. This information can be used to find entry points. Let us go to one of the previous charts to explain this better.
Here, take a look at the second crosshair. The first one shows the indicator entering the overbought area while the latter one shows the indicator leaving the overbought region. You can see that the reaction to the sell signal happens once the point in the second crosshair is crossed. Hence, that becomes an ideal entry point in the above example.
Similarly, the same idea can be applied in the case of oversold conditions as well. The point at which the indicator lines leave the oversold readings area is where the trigger happens, making it another ideal entry point.
You could also use the same point for stop-loss if you happen to enter a trade earlier.
Stochastic with other indicators
A combination of technical indicators always seems to work better, especially in minimising false signals. The same is true in the case of stochastic oscillators too.
Pivot points show multiple support and resistance levels. A buy or sell signal is usually around one of the resistance levels. If both the indicators agree on a buy or sell signal simultaneously, it increases the chance for a good trade. At the same time, if both the indicators show opposite readings, either one could be showing a false signal, and hence, you need to be cautious.
Moving average is a similar indicator that could prove to be helpful.
Fast stochastic oscillator vs slow stochastic oscillator
The slow stochastic oscillator is more popular and modern and is made to correct some flaws the initial fast stochastic oscillator had. The faster version uses recent price data, while the slower version uses moving averages. Due to this, the former is more sensitive and gives you recent data but is more prone to false signals. On the other hand, the slower version takes more time to produce signals, but the signals it produces are much more accurate and reliable.
Stochastic vs Stochastic RSI – which is better?
Known as the indicator of the indicator, a stochastic RSI tries to provide the stochastic values of RSI. The upgraded version aims to be more reliable. But since stochastic RSI is not based on the stock price and instead RSI, the indicator tends to be more sensitive.
There is a plus and negative side to it. The advantage is that stochastic RSI could potentially give you more information. But the disadvantage is that it could be too dependent on the RSI value, which is just another indicator that can show false signals. Hence, the chance for false signals multiplies.
The choice between the two is based on your trading strategy, although a normal stochastic oscillator (slow) is the more used. The former is not available in all the charts as well.
The stochastic oscillator is a simple indicator that gives you one important piece of information – overbought or oversold readings. But the same, along with the movements of the lines, can be interpreted in different ways to form a number of trading strategies,
Is the stochastic indicator better than the relative strength index?
Both stochastic oscillator and relative strength index (RSI) are similar tools and are often used interchangeably. Both are leading, momentum indicating, and oscillating indicators as well. The indicators have similar objectives as well – both as used to gauge the strength of a stock price and to forecast possible trend reversals based on overbought and oversold conditions. But even though the aim of both the indicators is the same, the way they arrive at an answer is quite different.
The stochastic indicator often gives more comprehensive information, and it works on the theory that the closing price should be moving in the direction of an underlying trend. On the other hand, a relative strength index uses the speed of the price movement to gauge overbought and oversold levels.
Both stochastic oscillator and RSI are useful indicators. But RSI seems to work better in a trending market while stochastic oscillator works better in a choppy market.
Is the stochastic indicator better than the MACD?
MACD and stochastic oscillator are two indicators that aim to find similar signals but in a different ways. The stochastic oscillator tends to work better in choppy markets, while MACD is better in a trending market. But often, the combination of two (using one as the trend finder and the other as the confirmer) tends to give you better results.
What is the difference between fast stochastic and slow stochastic?
The slow stochastic oscillator is a more reliable version of the fast stochastic oscillator. The latter uses recent price data, while the former uses moving average date. Due to this, the fast stochastic oscillator tends to give you faster results but has a tendency to produce more false signals.