A stochastic oscillator is designed to identify overbought or oversold stock. The indicator can be used to help identify potentially overbought and oversold conditions, divergences, and trend direction.
“Stochastics measures the momentum of price. If you visualize a rocket going up in the air—before it can turn down, it must slow down. Momentum changes direction before price ... it is a very sophisticated tool.”
These are the words Dr. George Lane used to describe the stochastic oscillator, one of the most regularly followed technical indicators. Lane, a Chicago futures trader and early proponent of technical analysis, popularized the momentum indicator in the late 1950s.
Stochastics may be popular, but if you’re not clear on how to interpret “overbought” versus “oversold” stocks or how to identify trend direction, you’re not alone. Even some veteran traders have a hard time understanding the mechanics behind the stochastic oscillator. So, let’s break it down and look at how stochastics could potentially be incorporated into your trading.
The stochastic oscillator measures the distance between a stock’s closing price and its range of highs and lows over a specified period. As the stock closes near the high of the range, the stochastic oscillator rises, and as the stock closes near the low of the range, it falls. It’s based on the premise that as price trends higher, the closing price tends to cluster toward the higher end of the price range, whereas during a downtrend, the closing price tends to cluster toward the lower end of the price range.
Proponents like the stochastic oscillator because of its easy-to-remember range of zero to 100, its overbought versus oversold indications, and its ability to help signal divergences in stock price movement. According to Dr. Lane, the stochastic oscillator moves into overbought and oversold areas at readings above 80 or below 20, respectively.
The default calculations are based on a relatively simple formula, one that might look at home in a 10th grade math book.
The stochastic oscillator is plotted with two lines, the %K line and the %D signal line, defined as follows:
The stochastic indicator tends to be popular among technical traders, and you’re likely to find it in most charting platforms. There are three main stochastic oscillators: slow, fast, and full. The difference between the fast and slow versions is that the fast stochastic is more sensitive than the other. That’s because the %K line for the fast stochastic isn’t smoothed, whereas the %K line for the slow stochastic is smoothed by a three-period simple moving average (SMA). Think of the fast stochastic oscillator as a speedboat, able to change directions quickly amid rapidly changing conditions, while the slow stochastic oscillator is more like a yacht, taking more time to change course. The full stochastic oscillator is a version of the slow stochastic oscillator that can be fully customized by the user. You can choose the number of periods to smooth the %K and %D lines.
So, which stochastics do you use? That’s really a matter of personal preference. The fast stochastic is likely to give you more trading signals, the slow stochastic will probably give fewer signals, and the full can be somewhere between the two, depending on how you customize it. All three have a similar calculation and move between zero and 100. Try placing all three indicators on your charts and see which one you are more comfortable using.
Some traders say that stochastics, because of their sensitivity, can be a good indicator to use when a stock is trading in a range. But that’s not to say the stochastics can’t be used when a stock is in a strong trend or to identify trend reversals. You can always consider using the stochastics alongside other technical indicators to help determine potentially overbought and oversold stocks.
Let’s look at an example of how to apply the stochastic oscillator to look for divergences, identify overbought versus oversold conditions, and understand trend direction. In figure 1, you’ll see a price chart with a 20-period SMA overlay. The slow stochastic oscillator appears in the subchart below the price chart.
FIGURE 1: OVERBOUGHT VS. OVERSOLD CONDITIONS, DIVERGENCES, AND TREND DIRECTION. The stochastic oscillator can show where a stock may have gotten ahead of itself—to the upside as well as the downside. In this example, after an oversold condition, the %K (blue line) crossed over the %D (purple line) to the upside (a potential signal of positive momentum) shortly before price closed above its 20-day SMA (yellow line). A couple months later, the opposite occurred: “overbought” conditions, %K crossed below %D, price closed below the 20-day SMA, and price action diverged from %D. Chart source: The thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.
As with most oscillators, you should first know the direction of the short- or long-term trend of a stock: Is it rising or falling? It’s a good idea to determine the trend over a specific time period. In figure 1, we observed the trend over a 20-day period.
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Now let’s bring the slow stochastic indicator into the mix. The %K line often identifies extremes in price movement. When %K moves below 20, it indicates potential weakness (oversold), whereas if it’s above 80 (overbought), it indicates potential strength. In the left white rectangle in figure 1, the %K line reached oversold levels and then started moving higher. It crossed above the %D line—an indication of price trending higher. When price moved above its 20-day SMA, it further confirmed a possible start of an uptrend.
During the uptrend, the %K and %D were moving in and out of overbought levels while price was still above its upward trending 20-day SMA, indicating the trend was still in place. The first possible signal of a weakness in the trend was when price crossed below the 20-day SMA, the %K crossed below %D, and %K sharply fell to oversold levels (right white rectangle).
If you turn your attention to the %D line, you’ll see it crossed below 80, then turned up, and again turned lower. The lower %D highs occurring while price moved higher is an example of a bearish divergence and could indicate a price reversal.
Whether slow, fast, or full, stochastic oscillators each have their own individual traits. But the overbought/oversold indicator may require a bit of testing and experimenting with the values to best fit your style of trading. So, bring up the stochastic oscillators on the thinkorswim platform and try them out in your paperMoney® account.
While these principles are the foundation of technical analysis, other approaches, including fundamental analysis, may assert very different views.
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