The Stochastic Oscillator

In this post, we introduce the Stochastic Indicator and how to trade with it.

Introduction

Most available financial resources state that the stochastic indicator has been developed by Dr. George Lane during his time working for Investment Educators in the 1950’s. However, some sources claim that the oscillator was a discovery made by Ralph Dyant, then head of Investment Educators, or even by some other colleague at the firm or one of their relatives. The stochastic compares a stock closing price to its price range over a certain period of time (analysts conventionally use 14 periods as the default setting for the stochastic oscillator).

Depending on the analysis objectives, the time period could be set as days, weeks, or even months for an analyst willing to get a long-term view. A trader can also use an intraday timeframe.

Basics

The stochastic oscillator is a momentum indicator using support and resistance levels and refers to the position of the closing price in relationship to the price range over a period of time. It is calculated as the difference between the close and the low, divided by the price range (the difference between the high and low over a certain period of time). The result is noted %K, and for a 14-period %K, an analyst would use the most recent close and the absolute high and low over the 14-period preceding the analysis. Thus, the indicator takes a value between 0 and 1 and is expressed in percentage points. An additional line is plotted against %K acting as a trigger line and denoted %D. %D is just the 3-day simple moving average of %K.

Calculate and Interpret

The stochastic oscillator measures the position of the close relative to the high-low range over the chosen timeframe. A reading over 50% indicates that the close is somewhere in the upper half of the high-low range, whereas a reading under 50% indicates that the close is somewhere in the lower half of that range. A stochastic value over 80% indicates that the security is overbought and a crossover below that threshold represents a potential sell signal while a value below 20% indicates that the security is oversold and a crossover above that threshold indicates a potential buy signal. However, this indicator needs to be considered in conjunction with other indicators to provide meaningful insights. In fact, a reading over 80% could not be considered as a sell signal at all times, as securities can, at times, keep being overbought for a long period during a sustained uptrend.

Further Reading