What is a Stochastic Oscillator?
Stochastic Oscillator is a technical momentum indicator that gauges the relationship between a security’s closing price and its price range over a specific period of time. It was developed by Dr. George Lane in the late 1950s.
As Said By Dr. George Lane: the developer of the Stochastic;
“Stochastics measures the momentum of price. If you visualize a rocket going up in the air – before it can turn down, it must slow down. Momentum always changes direction before price.”
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Calculation of Stochastic Oscillator
The formula of Stochastic Oscillator is:
%K = (Current Close – Lowest Low)/(Highest High – Lowest Low) * 100
%D = 3-day SMA of %K
%K is the current stochastic value and %D is the 3 periods simple moving average of %K. The %K is the slow-moving stochastic indicator whereas %D is the fast-moving stochastic indicator.
The default period for the Stochastic Oscillator is 14, which can be days, weeks, months, or any time frame. A 14-period %K uses the most recent close, the last 14 periods highest high and the lowest low. The %D line is plotted along with %K to act as a trigger line.
Stochastic Oscillator Calculation Using Excel
You can calculate stochastic oscillator using excel by putting high, low, and closing data in excel and using the above formula of the stochastic oscillator.
stochastic oscillator Excel file to calculate stochastic oscillator.
What Stochastic Oscillator Tells You?
The stochastic oscillator is a range-bound indicator that oscillates between 0 and 100. The range is used for finding the overbought and oversold regions. Most analysts considered stochastic indicator over 80 is overbought, and under 20 is considered oversold.
The stochastic oscillator chart mostly consists of two lines, one reflecting the value of the oscillator for each period and one reflecting oscillator’s three-day SMA. Because the security’s price is expected to follow a momentum, the crossover of these two lines is considered to be a signal of reversal.
The divergence between the oscillator and security’s price action is also considered as a reversal signal. For instance, when a negative trend reaches a new lower low, but the oscillator points as a higher low, it might be an indicator that bearish are losing momentum and a bullish reversal is may happen.
The periods on the Stochastic Oscillator depends upon the traders and their personal preferences and trading style. A shorter period oscillator will produce a choppy pattern with many overbought and oversold regions, which is helpful for short term traders.
On the other hand, a longer period of the oscillator will take a higher time to produce the overbought and oversold regions.
Stochastic Oscillator Vs MACD
The stochastic oscillator’s main aim is to find the overbought and oversold region along with the security’s momentum, but the moving average convergence divergence or MACD’s only aim is to compare two different moving averages and follow a stock’s momentum.
The MACD and stochastic indicators can be used together for better measurement of a stock’s momentum and its overbought and oversold region. These two indicators are used by most technical analysts as a crossover to find a better stock for trading and earning some profit.
Limitation of Stochastic Oscillator
During a volatile market scenario this oscillator some time gives false breakout or a false alarm, which may lead to a losing trade. This may happen every time in less liquid markets and stocks. Stochastic works well, when combined with several other indicators like MACD, moving average, trend lines, etc.
Stochastic is a famous and trader favorite indicators, used by professional as well as naive traders and analysts. The oscillator also helps medium-term investors, to enter a stock or exit an existing holding.
Here is a video from YouTube on Stochastic Indicator
You can read: Trading with Oscillators On Google Books