The term stochastic is used to refer to a randomly determined process that can be analyzed statistically to infer conclusions. One of the most popular uses of stochastic models is in the financial sector and in the stock market. The stochastic oscillator is an important part of technical analysis that can help you determine the price action for an asset such as a stock, a commodity, or even a currency.

Out of the many indicators employed in technical analysis of the stock market, very few are as powerful as the stochastic oscillator. If you’re wondering what a stochastic indicator is and how it can help you trade better, here’s some information that can help you out.

What is the stochastic oscillator?

In the 1950s, Dr. George C. Lane developed a technical indicator and named it the stochastic oscillator. Unlike other traditional technical indicators that followed either the price or the volume, the stochastic indicator followed the momentum of the price of an asset. Since the indicator measured the oscillations in the price of an asset, it was referred to by Dr. George Lane as the stochastic oscillator. The indicator was developed based on the fact that there is always a change in momentum before a change in price.

How does the stochastic oscillator work?

The stochastic oscillator compares a specific closing price of an asset with a wide range of high and low prices over a given period of time. As a general rule of thumb, the stochastic oscillator is calculated by taking a 14-day time period as the standard. However, the time period can be changed and adjusted according to your specific needs as well. The value of the stochastic indicator for any specific time period is always between 0 and 100.

The formulas used for the stochastic oscillator

The indicator uses the following mathematical formulas to calculate the values.

K line Formula:

%K = 100 x (CP – L14) / (H14 – L14)

Where:

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

D line Formula:

D = 100 x (H3/L3)

Where:

H3 =  the highest trading price of the asset in the previous 3 trading sessions

L3 =  the lowest trading price of the asset in the previous 3 trading sessions

Both the K line and the D line formulas are used in tandem by the indicator to identify any major signals in the price charts of an asset. In recent times, charting software solutions have become extremely robust, and all these mathematical calculations are done by the tool itself.

What does the stochastic oscillator indicate?

This indicator is used to identify overbought and oversold trading signals for any asset, thereby enabling you to spot reversals in the price action. For instance, if the value of the stochastic indicator for an asset is more than 80, the said asset is considered to be in the overbought region. If the value is less than 20, the asset is said to be in the oversold territory. However, the indication of overbought and oversold territories should merely be taken as clues to future price movements and not as conclusive evidence of a reversal.

The relationship between the stochastic oscillator and Relative Strength Index (RSI)

The RSI is another technical indicator that is very similar to the stochastic indicator. Both of these tools are price momentum oscillators that are used widely by traders. To increase the accuracy of a buy or sell signal, traders often use the stochastic oscillator and the RSI in tandem. While the objective of these two technical indicators may be similar, the underlying theories are different.

The stochastic oscillator works on the theory that the price of an asset tends to close near its highs during market uptrends and near its lows during market downturns. RSI, on the other hand, works by measuring the velocity at which the price of an asset moves. When faced with a market that moves in trends, the RSI can be very useful for identifying overbought and oversold conditions. However, when the stock market moves sideways or choppily, the stochastic indicator is of more use.

Conclusion

The stochastic oscillator is an excellent technical indicator and is widely used along with the RSI. While it is still a powerful tool on its own, it is a wise idea to not go by the readings of the stochastic indicator alone. This is primarily because the indicator has a tendency to produce false trading signals. In certain situations, where the market volatility is high, the price movement of the asset may not match the trading signal generated by the indicator. Therefore, it is a prudent idea to utilize the stochastic oscillator along with other technical indicators such as the RSI and Moving Average Convergence Divergence (MACD).