Stochastic Oscillator is probably one of the rare indicators that are used by both seasoned veterans as well as novice investors. This indicator is perfect for making good entry and exit decisions. Let’s explore why.
What is a Stochastic Oscillator?
Stochastics basically measures the momentum of price. Assume that a rocket is going up in the air. Before it can turn down, it must first slow down. In a similar manner, momentum changes direction before the price.
George Lane created Stochastic Oscillator in the late 1950s for following the speed or momentum of price. But currently, the Stochastic Oscillator is mainly used for identifying oversold and overbought conditions.
How To Read The Stochastic Oscillator
Stochastic Oscillator is a two-line indicator that oscillates between 0 and 100. The two lines are labeled %K and %D. Stochastic Oscillator compares the closing price of a stock to its prices over a certain period of time (usually 14). The figure below shows Stochastic Oscillator.
The Stochastic Oscillator will basically show how the current price compares to the highest and lowest price of the stock over that period of time. This means that when the value of the indicator is
- Near 0 (Zero): The price is trading near or below the lowest low during the 14-day period.
- Near 100: The price is trading near or above the highest high during the 14-day period.
- Above 50: The price is trading within the upper portion of the 14-day period
- Below 50: The price is trading in the lower portion of the 14-day period.
How To Use Stochastic Oscillator For Reversals
Stochastic Oscillator can be used for identifying the momentum of a stock. When the Stochastic Oscillator is above 80, it means that the stock’s trend is quite strong. The value of Stochastic Oscillator above 80 is also referred to as overbought condition. Similarly, when the Stochastic Oscillator is below 20, the stock is said to be oversold.
But keep in mind that a stock can remain in oversold or overbought condition for a long time. In practice, traders usually use these overbought/oversold levels for identifying reversals.
For instance, if the Stochastic Oscillator is above 80, and then falls below 50, it means that the price is moving lower. On the other hand, if the value of Stochastic Oscillator was below 20 and then it rallies above 50, it means that the price is moving higher.
The figure below shows how the stock’s trend changes based on the change in the value of Stochastic Oscillator.
Stochastic Crossovers for Quick Trades
Many traders use the crossover of the %K (blue line) and %D (red/ orange line) for making quick entries and exits. The rule of thumb, in this case, is that when the blue line crosses the red line, take a signal in the direction of the cross.
This means that if the blue line crosses above the red line, go long. Similarly, if the blue line crosses below the red line, go short. This idea works best in conjunction with candlestick patterns to avoid false signals.
The figure below shows how traders can choose to go long or short based on the direction of the cross of the two lines of the Stochastic Oscillator.