Stochastic Oscillator is a momentum-indicator that makes use of resistance and support. It compares a security’s specific closing price to its price range over a specific period of time.
Stochastic Oscillator Trading Strategy
The Stochastic System follows the observation that prices tend to close near the high if the trend is upwards, and on downtrends it tends to close near the low.
The Stochastic Oscillator shows two strategy lines, which are the %K and the %D lines. The K line is the current value of the stochastic indicator while the D line is its moving average. The two lines move within 0 to 100 on the scale. The signal to watch out for is when the D line and the price of the security diverge.
A bearish divergence happens when the D line crosses above 80 and forms two declining peaks with prices going higher. A bullish divergence happens when the D line crosses below 20 and forms two rising bottoms with prices going lower.
The buy and sell signals depend on the K line crossing the D line. When the K line crosses the D line from above the 80 level, it generates a sell signal. When the K line crosses the D line from below the 20 level, it generates a buy signal.
Using the Stochastic Oscillator
The Stochastic oscillator can identify whether an asset is overbought or oversold, but it must be used together with trend analysis:
- If the Stochastic oscillator exceeds the 75 level, the asset could be overbought.
- If the Stochastic oscillator falls below the 25 level, the asset could be oversold.
When the oscillator leaves the 75 or the 25 level, it suggests turning points in the price movement:
- The Stochastic signals a good selling opportunity if the price crosses the overbought boundary from above.
- The Stochastic signals a good buying opportunity if the price crosses the oversold boundary from below.
Crossovers of the indicator and the signal line could also mean deal opportunities:
- Crossing the signal line from below suggests buying opportunity.
- Crossing the signal line from above suggests selling opportunity.
Convergence or divergence patterns could indicate trend weakness:
- It indicates an uptrend weakness if the price reaches a new high but the indicator does not.
- It indicates a downtrend weakness if the price drops to a new low but the indicator does not.
Stochastic Oscillator Formula
To calculate the stochastic oscillator, get the difference between the closing price and the low price over n periods and the difference between the high and low prices over n periods. Then divide the two. To get an absolute range between 100 to 0, multiply the fraction by 100. The number of time periods is set by the trader.
Stochastic = 100 x ((C – L)/(H – L));
Signal = average of the last three Stochastic values;
C – latest close price;
L – the lowest price over a given period;
H – the highest price over a given period.