A stochastic oscillator measures the distance between a stock’s closing price and the range of highs and lows to help identify turning points.
"It doesn’t follow price, it doesn’t follow volume or anything like that. It follows the speed or the momentum of price. As a rule, the momentum changes direction before 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."
These are the words Dr. George Lane used to describe the stochastic oscillator, one of the most regularly followed trend indicators. Lane, a Chicago futures trader and early proponent of technical analysis, developed the momentum indicator in the late 1950s. Not clear on stochastics, or how to interpret “overbought" or “oversold" stocks? You’re not alone. Even some veteran traders have a hard time understanding the mechanics behind this technical indicator. So let’s break it down and look at how stochastics can 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. Proponents like the stochastic oscillator because of its easy-to-remember range of zero to 100, its support and resistance indications, and its ability to help signal divergences in share movement. According to Dr. Lane, the stochastic oscillator moves into overbought and oversold areas 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. It’s plotted with two lines, the %K line and the %D signal line, defined as follows:
There are three main stochastic oscillators: slow, fast, and full. The difference between the fast and slow versions is simple: one is more sensitive than the other. 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.
Some traders say that stochastics, because of its sensitivity, can be a good indicator to use when a stock is trading in a range, but when a stock is in a strong trend, a stochastic chart can often show inconsistent and false signals. With that in mind, it might help to use stochastics alongside other technical indicators to help determine overbought and oversold stock conditions.
As with most oscillators, you’ll first need to know the directional trend of the stock: rising or falling. And you’ll need to determine that trend over a set time, for example, a 20-period simple moving average (SMA), as shown in figure 1. A move above the 20-day SMA shows a potential bullish entry signal. Conversely, a potential exit presents itself when the stock closes below the 20-day SMA.
FIGURE 1: ENTRY/EXIT SIGNALS, OVERBOUGHT/OVERSOLD CONDITIONS. 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 crosses over the %D to the upside (a potential signal of positive momentum), roughly concurrent with a price close above the 20-day SMA (a potentially bullish signal). A week later, the opposite occurred: “overbought" conditions, a cross of the %K below the %D, and a close below the 20-day SMA. Image source: the TD Ameritrade thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.
The slow stochastic oscillator can sometimes be used to signal the beginning of a trend change when combined with other technical triggers. For example, if the indicator crosses up from below the 20 level at the same time that a reversal pattern occurs on a candlestick chart, it may be a strong sign that the trend is changing. Figure 1 shows an example.
Whether slow, fast, or full, stochastic oscillators each have their own individual traits that can be exploited to your benefit. But the overbought/oversold indicator may require a bit of testing and experimenting with the values to best fit your style of trading.
for thinkMoney ®
Financial Communications Society 2016
for Ticker Tape
Content Marketing Awards 2016
TD Ameritrade does not make recommendations or determine the suitability of any security, strategy or course of action, for you through your use of trading tools or technical trading indicators. Any investment decision you make in your self-directed account is solely your responsibility.
Market volatility, volume, and system availability may delay account access and trade executions.
Past performance of a security or strategy does not guarantee future results or success.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.
Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.
The information is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy, and is for illustrative purposes only. Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
This is not an offer or solicitation in any jurisdiction where we are not authorized to do business or where such offer or solicitation would be contrary to the local laws and regulations of that jurisdiction, including, but not limited to persons residing in Australia, Canada, Hong Kong, Japan, Saudi Arabia, Singapore, UK, and the countries of the European Union.
TD Ameritrade, Inc., member FINRA/SIPC. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. © 2019 TD Ameritrade.