Stochastic Oscillator

Stochastic Oscillator: What It Is, How It Works, How To Calculate

The stochastic indicator is a standard indicator in any trading platform, but we rarely see it published or used in any Stochastic trading strategies. Compared to the RSI, stochastics seems much less popular. Is that because it’s less useful, or is this a hidden gem?

The stochastic indicator does work in a stochastic trading strategy. It performs quite well as a mean-reversion tool for stock indices. 

In this article, we explain what the stochastic indicator is, how it performs, show some stochastic trading strategies, and how stochastic compares to the more famous Relative Strength Indicator. We make a trading strategy based on the stochastic indicator.

Table of contents:

What is the stochastic oscillator?

A stochastic oscillator is a technical analysis tool used to identify overbought and oversold conditions in the market. It compares a security’s closing price to its price range over a certain period of time and is typically expressed as a number between 0 and 100.

It’s one of the most popular indicators, and it’s also quite useful. For a comparison, please see our ranking of the best oscillating trading indicators.

The stochastic indicator tracks the relationship of the closing prices in relation to the highs and lows over a defined number of days and smooths the result by using an average. Stochastics is an indicator and oscillator, presumably invented by George Lane as early as the 1950s George Lane referred to stochastics as a momentum indicator.

Further down in the article you find the calculation and Amibroker code which makes it more apparent what stochastics measure. Stochastics is a bit similar to the previous indicator we wrote about, the Williams %R:

The Williams %R is a pretty easy indicator to calculate and understand, while stochastics is slightly more complex.

As a result of the formula, stochastics fluctuates between 0 to 100. Zero or low readings indicate an oversold condition, while 100 or a high reading means an overbought condition. Because of this, stochastics is mainly used as a mean-reversion tool.

What does the stochastic oscillator measure?

The stochastics oscillator measures the recent strength of the stock (or whatever you are trading) and how it trades compared to the last x days. It doesn’t measure the velocity of the movement but how it fares today compared to the lookback period’s high and low readings.

If the current price is low compared to the high/low range over the preceding days, the reading is low, and vice versa.

What is the best setting for the stochastic oscillator?

There are no exact settings that work all the time. What works in stocks might not work in commodities like, for example, oil or natural gas.

Different settings in different instruments don’t indicate curve fitting. You can’t expect a particular style or strategy to work on various instruments. As you’ll experience, stochastics don’t work well on commodities, for example, while it works well in the stock market.

How is the stochastic oscillator calculated?

The Stochastic oscillator is calculated with two lines: a fast line which is called %K and a slow line called %D.

The %K is calculated by using an x-day lookback period. If we use a 5-day lookback period it reads like this: ( close – low(5) ) /( High(5) – low(5) ) * 100.  This number is then smoothed by an average of, for example, 3 days.

The %D is an average of x days of the %K. The code for Amibroker further down perhaps illustrates the formula both better and easier.

The light orange line is a 5-day %K with a 3-day smoothing, while the blue line is the 5-day %D. The indicator pane above shows %D as (5,3,3). The reason why is the default settings in Amibroker:

Stochastic indicator settings

How does the stochastic oscillator work?

Stochastics are mainly used as an oversold or overbought indicator. This works normally well in mean-reverting asset classes like stocks. Further below we provide examples of how you can utilize the indicator.

stochastic-trading

What is the difference between the RSI and the stochastic oscillator?

The relative strength indicator (RSI) is probably the most known and used technical indicator, and just as stochastic, the RSI oscillates between zero and 100.

The difference mainly boils down to RSI measuring the velocity of the movements, while stochastics measure where the stock is in relation to the low and high over the lookback period.

In practice, both indicators are pretty similar. The differences between most oscillating indicators are small. Below is a 5-day stochastics %K and RSI:

As you can see, the visual differences are small. However, despite the visual similarities, the quantified results can differ.

What is the best stochastic oscillator strategy?

This is the best stochastic oscillator strategy that we have found while backtesting the stochastic indicator.

Is the RSI a better indicator than stochastic oscillator?

Let’s test two straightforward strategies: we buy the S&P 500 when the 5-day stochastic (%K) and RSI are less than 20, and sell when it reaches 50.

Stochastics yields a CAGR of 7.37% and a profit factor of 2.09 over 251 trades. The RSI returns a CAGR of 3.63% and a profit factor of 2.02 over 106 trades (from 1993 until March 2021).

However, it’s hard to conclude anything. As always, you need to investigate the indicators yourself to make a valid comparison.

The code for the stochastic oscillator

Both the %K and the %D are included in the platform. However, if you still want to calculate %K yourself, the code would be like this:

stochastic1=( close – llv(l,5) ) / ( hhv(h,5) – llv(l,5) ) * 100;
stochastic=MA(stochastic1,3);
Plot(stochastic,”stochastic”,colorRed,styleLine);

If we insert the indicator into the chart, it looks the same as the one included in Amibroker:

Stochastic indicator trading rules

How to use the stochastic oscillator?

In trading, you get rewarded by thinking outside the box. Obviously, there are many ways to use an indicator.

You can use stochastic together with moving averages (long-term and short-term definitions of the same indicator), and support and resistance levels. The latter is a bit more complex to code, though, and is mostly used discretionary.

Does the stochastic indicator work?

Yes, the stochastic indicator does work, especially on short-term movements in the stock market. The stochastic trading strategies in this article show that the stochastic indicator works well. We know from previous articles that the IBS indicator works really well on stocks, and thus it’s no surprise to see stochastic performing well. However, just like the RSI, the results can be improved by including one or more filters. A stochastic indicator works by calculating the security’s closing price relative to its trading range over a certain period of time.

This calculation is expressed as a number between 0 and 100. When the indicator is above 80, the security is considered overbought and when the indicator is below 20, the security is considered oversold.

What Are the Benefits of Using a Stochastic oscillator?

The main benefit of using a stochastic trading indicator is that it can help identify potential buying and selling opportunities. By providing an indication of when a security is overbought or oversold, traders can make more informed trading decisions.

However, we recommend backtesting your trading ideas unless you want to trade blind. The past is normally a good indication as long as you avoid curve fitting.

What Are the Drawbacks of Using a Stochastic oscillator?

The main drawback of using a stochastic trading indicator is that it can produce false signals. The indicator is also lagging, meaning that it will only provide signals after the market has already moved.

However, false signals are part of trading. Even though the stochastic indicator produces false signals, it has proven to be pretty good at pointing out reversals in the stock market.

How Can I Use a Stochastic oscillator?

The most common way to use a stochastic trading indicator is to buy when the indicator is below 20 and sell when it is above 80. Additionally, traders can look for divergences between the indicator and the price of the security to identify potential reversals. Our research indicates that divergencies are not as useful as reversals. There are too many false signals when you use the stochastic indicator as a divergence indicator.

What is the Stochastic Oscillator and its purpose?

The Stochastic Oscillator is a technical analysis tool utilized by traders and analysts in financial markets to gauge the momentum of a particular asset’s price movement. Its purpose lies in identifying potential trend reversals or overbought/oversold conditions within the market. Developed by George C. Lane in the late 1950s, the Stochastic Oscillator compares the most recent closing price of an asset to its price range over a specified period, typically 14 periods. This comparison is then expressed as a percentage, indicating the position of the current closing price relative to the high-low range. The oscillator fluctuates between 0 and 100, with levels above 80 often interpreted as overbought conditions, suggesting that the asset may be due for a downward correction. Conversely, levels below 20 are considered oversold, indicating potential buying opportunities as the price may be poised for an upward reversal. By providing insights into the strength and potential direction of price movements, the Stochastic Oscillator aids traders in making informed decisions regarding entry and exit points, thus enhancing their trading strategies and overall profitability.

How does the Stochastic Oscillator measure momentum?

The Stochastic Oscillator measures momentum by comparing the closing price of a security to its price range over a specific time period. It calculates the relationship between the current closing price and the highest high or lowest low within that period, typically 14 days. This comparison is expressed as a percentage, indicating where the current price is within the recent trading range. The oscillator’s main premise is that as a market trend accelerates, the closing prices tend to close near the high of the trading range during an uptrend and near the low during a downtrend. By tracking this relationship, the Stochastic Oscillator provides insight into the strength and direction of momentum, helping traders identify potential trend reversals or continuation patterns.

Why is the Stochastic Oscillator useful in technical analysis?

The Stochastic Oscillator measures momentum by comparing the closing price of a security to its price range over a specific time period. It calculates the relationship between the current closing price and the highest high or lowest low within that period, typically 14 days. This comparison is expressed as a percentage, indicating where the current price is within the recent trading range. The oscillator’s main premise is that as a market trend accelerates, the closing prices tend to close near the high of the trading range during an uptrend and near the low during a downtrend. By tracking this relationship, the Stochastic Oscillator provides insight into the strength and direction of momentum, helping traders identify potential trend reversals or continuation patterns.

What are the key components of the Stochastic Oscillator formula?

The Stochastic Oscillator formula comprises several key components essential for its calculation. These components include the highest high and lowest low over a specified period, typically 14 periods. These values are used to determine the range within which the current closing price falls. Additionally, the formula involves calculating the current closing price’s position relative to this range, often expressed as a percentage. This percentage indicates the level of momentum or strength in the price movement. Finally, smoothing techniques, such as moving averages, are often applied to the resulting percentage to reduce noise and provide clearer signals for traders and analysts. Overall, these components work together to generate insights into potential overbought or oversold conditions in the market, aiding traders in making informed decisions.

How does the Stochastic Oscillator identify overbought conditions?

The Stochastic Oscillator identifies overbought conditions by assessing the current price of an asset relative to its recent price range. It accomplishes this by comparing the closing price of an asset to its price range over a specified period, typically 14 periods. The oscillator produces values between 0 and 100, with readings above 80 typically indicating that the asset is overbought. This means that the current price is at the high end of its recent range, suggesting that a potential reversal or correction may be imminent. Traders often interpret such overbought conditions as a signal to consider selling or taking profits, anticipating a possible downturn in price.

How does the Stochastic Oscillator identify oversold conditions?

The Stochastic Oscillator identifies oversold conditions by analyzing the relationship between the current closing price and the price range over a specific period, typically 14 days. It measures the level of the current closing price relative to the high-low range over that period. When the Stochastic Oscillator falls below a certain threshold, usually 20, it suggests that the current closing price is near the bottom of the price range and that the market may be oversold. This indicates that the asset may be undervalued and could potentially experience a price reversal or bounce back. Traders often use this signal as an opportunity to buy, expecting the price to rise as the oversold conditions correct themselves.

What is the typical range for the Stochastic Oscillator?

The typical range for the Stochastic Oscillator, a popular momentum indicator in technical analysis, spans from 0 to 100. This range helps traders identify potential overbought and oversold conditions within a given market. When the indicator rises above 80, it suggests that the asset may be overbought, signaling a potential downturn. Conversely, when the Stochastic Oscillator falls below 20, it indicates potential oversold conditions, suggesting a possible upward reversal. This range provides traders with valuable insights into market dynamics and potential trading opportunities.

How do traders interpret divergences in the Stochastic Oscillator?

Traders interpret divergences in the Stochastic Oscillator as potential signals for upcoming price reversals or shifts in momentum within a given market. Divergence occurs when the price of an asset moves in the opposite direction of the Stochastic Oscillator’s indicator readings. This phenomenon suggests a weakening or strengthening of momentum that may not be fully reflected in the current price action.

When the price of the asset makes a new high (or low), but the Stochastic Oscillator fails to confirm this with a similar high (or low), it’s referred to as a bearish (or bullish) divergence. This discrepancy indicates that the prevailing trend might be losing strength, and a reversal could be on the horizon.

Traders often use divergences in conjunction with other technical indicators or chart patterns to confirm potential trading signals. For instance, if a bearish divergence forms near a significant resistance level or a bearish reversal pattern like a double top, it could strengthen the conviction for a downside move.

Similarly, bullish divergences occurring near key support levels or within the context of a bullish reversal pattern may signal a potential upward reversal. However, it’s essential to exercise caution and not rely solely on divergences as trading signals, as false signals can occur, leading to losses if not properly confirmed.

How does the Stochastic Oscillator compare to other indicators?

When comparing the Stochastic Oscillator to other indicators, it’s essential to consider its unique features and how it complements or differs from other tools in technical analysis. One notable aspect of the Stochastic Oscillator is its sensitivity to both price momentum and potential trend reversals. Unlike some indicators that primarily focus on trend direction or momentum alone, the Stochastic Oscillator offers insights into overbought and oversold conditions within a given trading range.

One common comparison is with the Relative Strength Index (RSI). While both indicators can identify overbought and oversold conditions, they have different calculation methods and sensitivity levels. The Stochastic Oscillator typically reacts more quickly to changes in price momentum, making it potentially more responsive in volatile markets. On the other hand, the RSI may offer smoother signals, which some traders prefer for filtering out noise.

Another comparison often made is with the Moving Average Convergence Divergence (MACD) indicator. While the MACD focuses on the convergence and divergence of moving averages to identify trend changes, the Stochastic Oscillator emphasizes momentum within a specific price range. Traders may use both indicators in conjunction to confirm signals or to gain a more comprehensive view of market dynamics.

Additionally, the Stochastic Oscillator is frequently compared to other oscillators such as the Commodity Channel Index (CCI) or the Williams %R. Each oscillator has its unique calculation method and interpretation, but they all aim to provide insights into market momentum and potential turning points.

How frequently is the Stochastic Oscillator used in trading?

The frequency of usage of the Stochastic Oscillator in trading varies depending on the preferences and strategies of individual traders. However, it is a widely employed technical analysis tool among traders and is commonly utilized in both short-term and long-term trading scenarios. Traders often integrate the Stochastic Oscillator into their analysis to identify overbought or oversold conditions in the market, as well as to generate buy or sell signals based on the crossing of its signal lines or divergence with price action. Its popularity stems from its ability to provide insights into potential trend reversals and market momentum, making it a valuable tool in the toolkit of many traders across different financial markets.

What timeframes are suitable for analyzing with the Stochastic Oscillator?

The Stochastic Oscillator is typically utilized for analyzing shorter-term timeframes in the financial markets. It is particularly well-suited for assessing momentum and identifying potential reversal points within these shorter periods. Common timeframes include intraday charts such as 5-minute, 15-minute, or hourly intervals. However, it can also be applied to daily or weekly charts for swing trading strategies. Generally, the shorter the timeframe, the more frequent the signals generated by the Stochastic Oscillator, but it’s essential to ensure that the chosen timeframe aligns with your trading objectives and risk tolerance.

Can the Stochastic Oscillator be used in conjunction with other indicators?

Yes, the Stochastic Oscillator can indeed be utilized in conjunction with other indicators to enhance trading strategies and provide more robust signals. Integrating the Stochastic Oscillator with complementary indicators can offer a more comprehensive view of market conditions and increase the effectiveness of trading decisions.

One common approach is to combine the Stochastic Oscillator with trend-following indicators such as moving averages. For example, traders often look for Stochastic Oscillator signals that align with the direction of the trend indicated by moving averages. This helps filter out false signals and provides confirmation of potential entry or exit points.

Additionally, traders may incorporate other momentum indicators alongside the Stochastic Oscillator, such as the Relative Strength Index (RSI) or the Moving Average Convergence Divergence (MACD). By comparing signals from multiple momentum indicators, traders can gain a clearer understanding of market momentum and potential shifts in direction.

Furthermore, some traders integrate volume-based indicators with the Stochastic Oscillator to confirm price movements. Volume indicators like On-Balance Volume (OBV) or Chaikin Money Flow can provide insights into the strength behind price movements, validating signals generated by the Stochastic Oscillator.

It’s important to note that while combining indicators can enhance trading strategies, it’s essential to avoid overcomplicating the analysis. Traders should focus on using a coherent set of indicators that complement each other and provide clear signals without introducing unnecessary complexity. Additionally, thorough backtesting and analysis are crucial to ensure the effectiveness of any combined indicator strategy in different market conditions.

How does smoothing affect the Stochastic Oscillator’s signals?

Smoothing has a significant impact on the signals generated by the Stochastic Oscillator. By incorporating smoothing techniques, such as moving averages or exponential moving averages (EMAs), the Stochastic Oscillator’s signals become more refined and less prone to erratic fluctuations. Smoothing essentially filters out the noise in the price data, providing a clearer indication of underlying trends and momentum.

When smoothing is applied to the Stochastic Oscillator, it can help reduce false signals and improve the overall accuracy of the indicator. By smoothing out short-term price movements, the oscillator becomes less sensitive to minor fluctuations, resulting in a smoother, more reliable signal.

However, it’s essential to strike a balance when applying smoothing to the Stochastic Oscillator. Over-smoothing can lead to delayed signals, potentially causing traders to miss out on opportunities or react too slowly to market changes. On the other hand, insufficient smoothing may result in increased noise and false signals, leading to poor trading decisions.

Ultimately, the choice of smoothing parameters depends on the trader’s preferences, trading style, and the specific characteristics of the market being analyzed. Experimentation and backtesting can help determine the optimal smoothing settings for the Stochastic Oscillator in different trading scenarios.

What is a great video about the Stochastics Oscillator_

Here is a great video about the Stochastics Oscillator.

What are the limitations of the Stochastic Oscillator?

The Stochastic Oscillator, while a popular tool in technical analysis, does have its limitations. One primary limitation is its tendency to generate false signals, especially in ranging markets. This means that it can sometimes indicate buying or selling opportunities when the price is merely consolidating rather than trending. Additionally, the Stochastic Oscillator can become less effective during periods of low volatility, as it may produce erratic readings that are difficult to interpret accurately. Another limitation is its sensitivity to market noise, which can lead to frequent whipsaws, causing traders to enter and exit positions prematurely. Moreover, the default parameters of the Stochastic Oscillator may not be suitable for all market conditions or trading strategies, requiring adjustments and fine-tuning by traders. Lastly, like any technical indicator, the Stochastic Oscillator is not foolproof and should be used in conjunction with other analysis tools and market factors for more reliable trading decisions.

How do traders adjust settings for the Stochastic Oscillator?

Traders typically adjust settings for the Stochastic Oscillator by accessing the indicator’s parameters within their trading platform. These settings usually include the number of periods for the %K and %D lines, as well as optional smoothing parameters. By tweaking these settings, traders can tailor the Stochastic Oscillator to suit their specific trading strategies and timeframes. Common adjustments involve altering the period lengths to capture different levels of market momentum or volatility. Additionally, smoothing parameters can be adjusted to reduce noise and generate clearer signals. Overall, fine-tuning these settings allows traders to optimize the Stochastic Oscillator for better responsiveness to price movements and improved trading decisions.

What role does market volatility play in Stochastic Oscillator analysis?

Market volatility plays a crucial role in Stochastic Oscillator analysis as it directly impacts the interpretation and effectiveness of this technical indicator. The Stochastic Oscillator measures the momentum of price movements and helps traders identify overbought and oversold conditions in the market. In times of high volatility, price swings are more pronounced, leading to rapid fluctuations in the Stochastic Oscillator readings. This heightened volatility can amplify the signals generated by the oscillator, making it more responsive to changes in market sentiment and direction.

When the market is experiencing increased volatility, the Stochastic Oscillator tends to produce more frequent and potentially more significant overbought and oversold signals. Traders must be cautious when relying on these signals during volatile periods, as false signals can occur more frequently due to the erratic nature of price movements. Additionally, extreme volatility can lead to distorted readings on the Stochastic Oscillator, making it challenging to accurately assess market conditions.

On the other hand, periods of low volatility may result in less reliable signals from the Stochastic Oscillator, as price movements may be more subdued and less indicative of true market sentiment. Traders should consider adjusting the parameters of the oscillator or incorporating additional technical indicators to account for varying levels of volatility and improve the accuracy of their analysis.

How do traders spot potential trend reversals using the Stochastic Oscillator?

Traders utilize the Stochastic Oscillator to identify potential trend reversals in the market. This technical indicator helps them gauge momentum by comparing a security’s closing price to its price range over a specific period. The Stochastic Oscillator consists of two lines, %K and %D, which oscillate between 0 and 100. When the %K line crosses above the %D line in the oversold region (typically below 20), it suggests a bullish reversal might occur, indicating that the asset might be undervalued and due for an upward movement. Conversely, when the %K line crosses below the %D line in the overbought region (typically above 80), it indicates a potential bearish reversal, signaling that the asset might be overvalued and poised for a downward trend. Traders often look for divergences between the Stochastic Oscillator and the price movement, where the oscillator forms higher highs or lower lows while the price behaves differently, indicating a possible reversal in the current trend. By interpreting these signals, traders can make informed decisions about entering or exiting positions in the market.

What is the difference between the %K and %D lines in the Stochastic Oscillator?

The distinction between the %K and %D lines in the Stochastic Oscillator lies in their respective calculations and the smoothing techniques applied to each. While both are essential components of the oscillator, they serve slightly different purposes in assessing market momentum and potential turning points.

The %K line represents the current closing price relative to the high-low range over a specified period, typically 14 periods. It measures the momentum of the price action and is often more volatile as it responds quickly to market fluctuations. Traders often interpret %K crossing above or below certain threshold levels, such as 80 and 20, as signals of overbought or oversold conditions, respectively.

On the other hand, the %D line, also known as the signal line, is a smoothed moving average of the %K line. Its purpose is to provide a more stable view of the momentum trend by reducing noise and false signals inherent in the %K line. The most common smoothing method for the %D line involves applying a simple moving average to the %K line, typically over a 3-period period. This smoothing helps traders identify broader momentum trends and potential reversals more clearly.

How do traders use crossovers in the Stochastic Oscillator to make decisions?

Traders utilize crossovers in the Stochastic Oscillator as a pivotal point for decision-making within their trading strategies. The Stochastic Oscillator, a momentum indicator, helps traders identify potential reversal points in the market by comparing the closing price of an asset to its price range over a certain period.

Crossovers in the Stochastic Oscillator occur when the %K line, representing the current price relative to the price range, intersects with the %D line, a moving average of %K. These crossovers are significant as they indicate shifts in momentum and potential changes in the direction of the price trend.

When the %K line crosses above the %D line, it suggests a bullish signal, indicating that buying pressure is increasing and potentially signaling an uptrend. Conversely, when the %K line crosses below the %D line, it indicates a bearish signal, suggesting that selling pressure is increasing and potentially signaling a downtrend.

Traders use these crossovers as entry and exit points for their trades. For instance, a trader might initiate a long position when the %K line crosses above the %D line, anticipating a bullish trend, and exit the trade when the %K line crosses below the %D line, signaling a potential reversal or loss of momentum.

Additionally, traders may incorporate other technical indicators or fundamental analysis to confirm signals generated by Stochastic Oscillator crossovers and to mitigate risks associated with false signals. By combining crossovers with other indicators and market analysis, traders aim to enhance the probability of successful trades and manage risk effectively in various market conditions.

What strategies can traders implement using the Stochastic Oscillator?

Traders can implement various strategies utilizing the Stochastic Oscillator to enhance their decision-making processes in the financial markets. One common approach is to utilize overbought and oversold conditions indicated by the oscillator. When the Stochastic Oscillator surpasses the 80% threshold, suggesting overbought conditions, traders might consider initiating short positions or liquidating long positions. Conversely, when the oscillator drops below the 20% level, indicating oversold conditions, traders might contemplate entering long positions or closing out short positions. Another strategy involves identifying divergences between the price action and the Stochastic Oscillator. If the price forms higher highs while the oscillator forms lower highs (bearish divergence) or lower lows while the oscillator forms higher lows (bullish divergence), it could signal potential reversals in the price trend. Traders might use these divergences as early warning signs to anticipate trend reversals and adjust their trading positions accordingly. Additionally, traders can employ the crossover of the %K and %D lines within the Stochastic Oscillator. When the faster %K line crosses above the slower %D line, it suggests upward momentum, potentially signaling a buying opportunity. Conversely, when the %K line crosses below the %D line, it indicates downward momentum, possibly signaling a selling opportunity. By combining these strategies with other technical indicators or fundamental analysis, traders can develop robust trading strategies to navigate various market conditions effectively.

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