Understanding the Stochastic Oscillator

Widely promoted by Dr. George Lane in the 1950’s the Stochastic Oscillator is a momentum indicator which uses both support and resistance levels. Stochastic refers to the current price in relation to the price range of the instrument over time. The idea behind the method that one can predict turning points by comparing the close price of the instrument in question to the value of the Stochastic Oscillator. 

The Stochastic Oscillator measures the last close relative to the high and low range over a certain period of time. Interpreting the Stochastic Oscillator is a relatively easy task even if calculating it is not so simple. The Stochastic Indicator measures the last close relative to the high-low range of a certain period of time giving us a numerical number which is often displayed on a graph below the instrument; a reading of above 50 means that the instrument is in the upper half of its set historical range while a reading below 50 means that instrument is trading in the lower half of the historical range the trader has chosen. Readings above 80 show that the instrument is near its high in the given time period while readings below 20 show that the instrument is near to lowest close. 

The Stochastic Oscillator often comes in three different varieties; fast, slow and full. With the Fast version being the closest to Dr. George Lane’s original formula for calculating the stochastic oscillator. When using the three different varieties you will notice some minor differences between the graphical depiction of the indicator with the fast line appearing more choppy than the others. 

Using Stochastic Oscillator as Overbought and Oversold Indicator 
Being a bound indicator, the Stochastic Oscillator can be used easily to identify overbought and oversold levels. The Oscillator ranges from 0 to 100 regardless of any sharp declines or increases in price, making it a simply to use when determining whether an instrument is oversold or overbought. Traditional settings use 80 as the overbought threshold and 20 as the oversold threshold, however these levels can be adjusted to suit the particular instrument you are trading. In regard to the traditional use, readings above 80 for a 15 day Stochastic Oscillator would indicate that the underlying instrument was trading towards the top of its 15 day high. Conversely readings below 20 suggest that the instrument is trading towards its 15 day low point. 

However it is important to note that overbought and oversold are not necessarily bearish or bullish. For example instruments can become overbought and stay overbought during a strong upward trend. If you notice a trend of closes that keep the oscillator towards its upper bounds, it is a good sign of sustained buying pressure. Therefore it’s important to identify the bigger trend and then trade in the direction of the trend. 

Bull & Bear Divergences 
A divergence forms when a new high or low price is not confirmed by the Stochastic Oscillator. Bullish divergences occur when a price drops lower but the Stochastic Oscillator forms a higher low. This is meant to show less downside momentum and is meant to foreshadow a price reversal. Bearish divergences occur when the price records a new high but the Stochastic Oscillator records lower highs, this suggests less upside momentum and is meant to foreshadow a dip in price. In traditional analysis a bullish divergence is confirmed with Stochastic Oscillator break above 50 and bearish divergence is confirmed when the Stochastic Oscillators drops below 50. All this is very difficult to explain and is best illustrated through the use of charts.  

When using the Stochastic Oscillator 50 is a very important level to watch. As 50 is the center line between the two extremes, therefore a crossover is something to look for as it shows that price either trading in the upper half of the range or it is trading in the lower half and can signal movement one way or the other.  

Conclusion 
Oscillators are best suited for determining trading ranges, though they can also be used with securities that trend. The Stochastic Oscillator is great for determining opportunities in line with the underlying trend. The exact setting to use on a Stochastic Oscillator is really down to what your personal preferences are and what instrument you are trading. A shorter look back indicator will produce a more choppy oscillator with more overbought and oversold readings. As with many technical indicators its important to use it conjunction with other technical indicators to either confirm or deny the trends.

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