Stochastic Oscillator is a highly useful indicator. This indicator shows the relationship of the current closing price to its price range over a period of time.
The indicator was developed in the late 1950s by George C. Lane, the president of Investment Educators Inc.
The purpose of the Stochastic Oscillator – to identify price trends and reversals by tracking the position of closing prices within the recent series of highs and lows. Stochastic is constructed on the basis of the following regularity of the market price behaviour: at the uptrend, closing prices tend to the top of the price range, and at the downtrend – to the bottom, respectively.
Stochastic was originally designed for market trading in a flat state; thus, it, like other types of Oscillators, functions quite well in the absence of any trend. Trend movements use the difference between the trend of the price chart and the indicator as a signal of a possible adjustment or reversal.
Stochastic Oscillator consists of two lines – fast, %K, and slow, %D, and is displayed in a separate window under the price chart. Since the indicator is calculated as a percentage, with a fluctuations range from 0 to 100.
The indicator is defined as follows:
%K = 100*(closing price – L)/(H-L),
%D = 3*period exponential moving average of %K.
Using the Stochastic Indicator
1. Transaction Signals
When the fast % K line crosses the slower % D line from bottom to top, this is a buy signal; when the% K line crosses % D from top-down, a sell signal is generated. The crossing signals are mostly used along with a second type of signal – output from overbought/oversold levels.
2. Output from Overbought/Oversold Levels
Setting of overbought/oversold thresholds is a type of applying the Stochastic. Stochastic Oscillator readings below 20 indicate that the market is in the oversold phase; readings above 80 –the market is in the overbought phase.
The buy signal is incoming when the Stochastic Oscillator falls below 20 and then crosses the line from the bottom upwards.
The sell signal is incoming when the Stochastic Oscillator rises above 80 and then breaks through the line from the top downward.
Fig.1 Buy/Sell Signals Upon Reaching Closing Levels
Other level combinations, such as 30 and 70, are used as well. Additionally, you can add 50 as the level of adjustment. When Stochastics reaches 50 upon the simultaneous convergence of lines %K and % D, it indicates the possible termination of further movement. While a firm crossing of the level by the indicator lines shows a strong trend.
Like with other types of Oscillators, another way of using signals of the Stochastic Oscillator is the study of its divergences (discrepancy between Oscillator readings and price). Divergence is a signal of reversal. It points to the fact that the future price trend may be determined by the Oscillator.
A bullish divergence occurs when price records a new lower low, but the Stochastic meanwhile forms a higher low on its chart.
A bearish divergence occurs when price records a new higher high, while the Stochastic indicator forms a new high on its chart – lower the previous one, indicating that the reversal of upward movement down may begin soon.
Thus, the buy signal is incoming as follows:
1. Stochastic falls below the line 20 and then crosses this line from bottom to top, with the %K crossing %D bottom-up;
2. The price continues to decline, and this trend is not supported by Stochastic (uable to fall below the previous low).
The sell signal is incoming as follows
1. Stochastic Oscillator rises above 80 and then crosses the line from the top downward, with the %K crossing %D top-down;
2. Prices reach new extremes, while the Oscillator cannot rise higher than the previous peak.
There are strategies that apply the Stochastic as the only indicator. In that case, signals are received from different time periods. If a weekly Stochastic goes up, a daily chart should receive just buy signals, and, respectively, if a weekly Stochastic goes down, the daily chart should receive sell signals only. In this case, the weekly Stochastic determines the direction of the trend. A similar algorithm can be applied to smaller time intervals. This operation principle allows to open positions only for of a strong market trend.
Stochastic is a right indicator, though, it issues lots of false signals within a trend. To avoid this, within a certain trend I use a Stochastic only for that trend. It is therefore highly important to properly define the trend. It influences the profitability of many strategies. Therefore, my next article will be dedicated to description of methods to define the trend and combine it together with the Stochastic into a profitable strategy.