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

%K is the slow-moving indicator, and %D is a fast-moving indicator measured by the 3-period moving average of %K.

The general rule of thumb of stochastic oscillator suggests that when the market is moving upward, the asset price will close near the high. Similarly, the stochastic oscillator value will close near the low when the market is trending downward.

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 stochastic chart contains two lines – one line showing the actual value of the oscillator, and the other is the 3-day moving average of the previous line. These two lines move in tandem and generate trading signals when the slow-moving stochastic line crosses the moving average line. A stochastic oscillator chart can foretell a trend reversal when the %K line crosses the %D line.

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.

How To Trade With Stochastic Oscillator

Stochastic oscillator moves along with an asset’s price, establishing a relationship between the asset’s closing price and the price range. To date, the stochastic oscillator is one of the most widely used oscillators and favoured for accurately predicting the market. It is easy to understand, and with the help of modern technical tools, one can calculate the %K and %D values quite easily.

If your wish is to become an active trader, learning to predict the market with stochastic oscillator will come handy in identifying potential trades. Traders often use stochastic oscillator for the following purposes.

– Scalping

– Overbought/oversell confirmation

– Divergence

– Daily swing method with Admiral Pivot

Stochastic oscillator assumes that momentum precedes price, compares asset’s closing price against a preset price range. If you are building a trading strategy around a stochastic oscillator, you need to watch for two things – trend reversal signal and divergence.

When The two lines in the stochastic oscillator chart intersect, it signals a possible reversal caused by a large shift in day-to-day momentum.

Similarly, widening divergence between oscillator and trending price line can indicate a possible change in the ongoing trend. For instance, when a bearish trend records a new lower low, but the oscillator stays above the new price, it may be an indication that bear is possibly losing the steam and a reversal may be in the offing.

The stochastic oscillator is a powerful trading tool while used with caution.  Avoid making mistakes while using it to predict a trade if you don’t want to lose hundreds and thousands of money.

Two common rookie mistakes that traders can make are:

– Going long when the market is oversold, as the market can continue to decline and you end up making a costly mistake

– Considering every divergence as a possible reversal. There can be occasions where the two indicators point in two different directions, but no reversal takes place in reality

To avoid making mistakes, traders use a stochastic oscillator together with other technical trading tools like the RSI. The general rule of thumb suggests that when you can’t confirm a reversal, continue trading in the direction of the trend and not against it.

Conclusion

Stochastic oscillator serves the same purpose as other indicators, indicating when an asset price moves to overbought or oversold regions.

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)