Stochastic Oscillator

The stochastic oscillator is a technical indicator used by trades to analyse the price of an asset (stocks, commodities or currency). With the help of this indicator, traders can understand if the price of an asset is high (overbought) or low (oversold) compared to its recent range. It was developed by Dr George Lane in the 1950s to help traders predict possible changes in the price direction. Stochastic oscillator helps traders understand if the price is likely to go up, go down or remain the same by comparing the daily closing price of the asset with its high and low points. xIt follows the price momentum of the asset. This means it is based on how fast or slow the price is moving.  Let’s explore what is stochastic oscillator in this blog.

How does the Stochastic Indicator Work?

Now that we have seen what is a stochastic oscillator, let us see how it works. The stochastic indicator measures the position of the asset’s closing price compared to its price change. It operates on the idea that prices tend to close near the high in an upward-trending market and they close near the low in a downward-trending market. It shows this information with the help of two lines, namely the %K line and the %D line. The %K line is the main line. It shows the momentum of the price movement. The %D line is the 3-day average of the %K line and helps confirm the changes in the trends.  

The stochastic indicator provides values between 0 and 100. Readings above 80 indicate that the asset might be overbought (priced too high) while readings below 20 indicate that the asset might be oversold (priced too low). This could mean that the asset may soon follow an upward trend. The stochastic indicator allows traders to see when a price trend might be about to change direction (trend reversals). Traders often look for crossovers between these two lines as potential buy or sell signals. The stochastic oscillator is often calculated by taking 14 days. 

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Stochastic Indicator Formula

The stochastic oscillator formula allows us to calculate the value of the %K line. %D line value is the 3-day simple moving average of %K. These values show us how close the current price of the asset is to the highest and lowest prices over a specific time, typically the past 14 days. The formula for calculating the %K is given below. 

%K = 100(C - L14)/(H14 - L14)  

where,

• C is the stock’s most recent closing price.
• L14 is the stock’s lowest price in the last 14 days. 
• H14 is the stock’s highest price in the last 14 days. 

Let us understand it with an example.

Let us assume, that the current price is Rs. 50, the stock’s lowest price is Rs. 40 and the highest price is Rs. 60. If we put these values in the formula, the %K value comes out to be: 

%K = 100*(50-40)/(60-40) = 50.  

%K is 50 This means that today’s closing price is halfway between the recent high and low.

How to Read the Stochastic Oscillator Indicator

The value of a stochastic oscillator is always between 0 and 100. Analysing the stochastic oscillator involves understanding its values and signals. The meanings of some of the value ranges are given below.  

• Above 80: If the value is above 80, it might indicate that the stock might be overbought and the prices may correct themselves soon. 
• Below 20: If the value is below 20, it might indicate that the stock might be oversold and suggests a possible upward reversal. 
• Crossover: The trader might notice a buying opportunity if the %K line crosses above the %D line. On the other hand, the trader might see a selling opportunity if the %K line crosses below the %D line.
• Divergence: If the price is making a new high but the stochastic oscillator is not, it may suggest that a trend reversal is coming. 

Stochastic Oscillator Trading Strategies

Traders use the stochastic oscillator to identify exit and entry points in a stock. The trading strategies that use stochastic oscillators are listed below. 

Overbought/Oversold Signals

An above 80 oscillator value indicates that the stock is overbought. This is when traders look to place a buy trade. On the other hand, a below 20 oscillator value indicates that the stock is underbought. This is when traders look to place a sell trade. 

Stochastic Divergence 

A bullish divergence occurs when the stock price hits a new low, but the stochastic oscillator makes higher lows. This means that the trend is likely to reverse upwards. On the other hand, a bearish divergence occurs when the stock price hits new highs while the stochastic oscillator shows lower highs. This means that the trend is about to turn down.

Stochastic Crossovers

In this strategy, if the %K line crosses above the %D line in the oversold region, it generates a buy signal. Whereas, if the %K line crosses below the %D line in the overbought region, it generates a sell signal. 

Conclusion
The stochastic oscillator is a valuable indicator for traders looking to gauge market momentum and predict price momentum. It also helps traders spot overbought and oversold conditions. By understanding its workings and applying effective strategies, traders can enhance their decision-making processes. However, it is suitable to use it with other technical indicators available on online trading apps to confirm signals and arrive at optimal results.