Stochastic Oscillator

Developed by George Lane | A popular momentum indicator

About Stochastic Oscillator

Stochastic Oscillator (often called Stochastic) is a momentum indicator that compares current closing price with its range (highest and lowest price) over a certain period of time. This indicator does not follow price or volume, but it follows rate of change of prices or momentum. Developed in the 1950s by George Lane. It is a very popular momentum indicator.

Stochastic Oscillator chart consists of two lines, one which reflects actual value of oscillator (%K or main line), and another which uses Simple Moving Average period 3 (SMA-3) of the %K line. This line is called the signal line. Price movements are assumed to follow momentum, so the crossover of these two lines are thought to be an indication of reversal, since it indicates large shift in momentum.

Understanding Stochastic Number

Value of stochastic indicator is range-bound between 0 and 100. Low stochastic number (below 20) means that current price is near the low of the price range. In other words, price is currently less than 20% away from the low of the price range.

High stochastic number (above 80) means that current price is near the high of the price range or price is currently less than 20% away from the high of the price range.

Level above 80 is considered as overbought. Level below 20 is considered as oversold.

Please keep in mind that in a strong up trend/down trend moves, an instrument can be in overbought/oversold condition and still continue to rise/fall and stay in that condition for a prolonged period of time. Overbought readings are not necessarily bearish and oversold readings are not necessarily bullish.

Trading Application

Reversal

BUY when stochastic is above the signal line and crosses above level 20.

SELL when stochastic is below the signal line and crosses below level 80.

Divergence

Bullish divergence happens when prices fall but stochastic oscillator does not fall.

Bearish divergence happens when prices rise but not accompanied by rise in stochastic.

Trend

BUY when stochastic is above signal line and crosses above level 80. Close position when stochastic is below signal line and crosses below level 80.

SELL when stochastic is below signal line and crosses below level 20. Close position when stochastic is above signal line and crosses above level 20.

Reversal

Chart below shows example of stochastic reversal. When stochastic is above signal line and crosses above level 20, BUY at open of next bar/candle. Blue circles show when stochastic is above signal line crosses above 20. Blue arrow show the BUY positions taken.

When stochastic is below signal line and crosses below level 80, SELL at open of next bar/candle. Red circles show when stochastic is below signal line and crosses below 80. Red arrows show the SELL positions taken.

Divergence

When prices and stochastic do not move in the same direction, we have a so-called divergence, which indicates that price could be changing direction soon. Chart below shows example of bearish divergence and bullish divergence between prices and stochastic.

Blue circle (1) shows bearish divergence. Price rising but not followed by stochastic. This indicates possible change of direction from up to down.

Red circle (2) shows bullish divergence. Prices falling, but stochastic rising. This indicates possible change of direction from down to up.

Trend

Another way to use stochastic is by following the current trend. When stochastic is above signal line and crosses above level 80 (blue-colored area), BUY at open of next bar/candle (blue arrow). Close out position when stochastic is below signal line crosses below 80 (orange cross).

When stochastic is below signal line and crosses below level 20 (red-colored area), SELL at open of next bar/candle (red arrow). Close out position when stochastic is above signal line and crosses above 20 (orange cross).

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