What is a Stochastic Oscillator?
Developed by George Lane, the stochastic indicator essentially acts as a momentum guide. This is used to gauge the potential future direction in trending markets by spotting the areas where the beginning of a change in direction can take place.
A stochastic usually show the traders the relationship between the closing price and the previous high-low price range over a specified period of time. According to Lane himself, the aim of the stochastic oscillator is not to track price nor volume, but the speed of flow or momentum.
The stochastic oscillator is calculated with the below formula
K line ( blue below) = 100 [(C – L5 Close)] / (H5 – L5)
- C = the most recent closing price
- L5 = 5 session low
- H5 = 5 session high
D line (red dotted below) = 100(H3 / L3)
- H3 = 3 session high
- L3 = 3 session low
Type of Stochastic’s?
Stochastic’s fall under the oscillator umbrella of indicators. Under this umbrella are the likes of the MACD, Average True Range and DeMarker. Although separate if their individual functions they have similarities in what they hope to show a trader.
When it comes to stochastic’s, and beyond the stochastic oscillator itself, another type that is closely aligned to it is the Relative Strength Index. We look at both below.
Here you see the 2 lines detailed above (K/D) with a range on the y-axis 0-100, with 20 and 80 the other headline numbers. The K line moves faster than D, however, when the 2 meet and crossover is where you see the momentum change.
The red circles show where the momentum changes after an upwards trend, then reversing and sellers enter, this change begins to take place the closer it gets to 80. The blue circles show where the momentum changes after a downwards trend, then reversing and buyers enter. This change begins to take place the closer it gets to 20.
Relative Strength Index
Here you see a range on the y-axis 0-100, with 30 and 70 the other headline numbers. The red circles show where the momentum changes after an upwards trend, then reversing and sellers enter. This change begins to take place the closer it gets to 70. The blue circles show where the momentum changes after a downwards trend, then reversing and buyers enter. This change begins to take place the closer it gets to 30
How can you use Stochastic’s to buy/sell?
In spotting the momentum of the markets and the correlation between close (price) and the price range (high-low), a trader can use this information to see if a market is either overbought or oversold.
As seen above, when the markets reach close to 80, they may believe that the potential for a turnaround exists as the markets are near overbought levels. So a trader may look at the possibility of selling a market at this level.
When below or close to 20, this is closer to being oversold, so a trader may look at this as a good level to buy.
Generally, no indicator should be used as a standalone, but rather just one of many driving forces in helping to make an overall decision.