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The Beginner’s Guide to Stochastic Oscillators
I’ve been getting a few email or social media questions about technical indicators again. It usually goes something like this …
“Tim, what technical indicators do you use?”
Then I answer something like this …
“I keep things simple. I use basic support and resistance. I use patterns — the same patterns I’ve been using for the last 20 years. I follow the chart and the price action. I look for catalysts to help form a thesis. I follow my plan and cut losses quickly. I’m careful about position sizing. I keep using what’s working now until it isn’t working. Then I adapt.”
Then, the person who contacted me completely ignores my reply. They come back with something like this: “Thanks, Tim. What do you think about MACD? How about VWAP? Oh, and I’m really into using stochastic oscillators but I don’t know which is best. Fast or slow stochastic oscillator? What do you think, Tim?”
You ever have conversations like this? It’s kinda frustrating.
Table of Contents
Two things before I go any further with stochastic oscillators …
First: apply for the Trading Challenge right now. Do it. It’s awesome. You’ll learn how to trade. That’s what you want, right?
Second: If you’re not ready for the Trading Challenge, then read “The Complete Penny Stock Course” by my student Jamil Ben Alluch. Notice the title includes the word complete. I assure you, there is no mention of stochastic oscillators in Jamil’s book. None. Zero. Nada.
Also be sure to check out my 5,000+ word Guide on Trading Penny Stocks for Beginners.
The number one technical indicator you’ll find in “The Complete Penny Stock Course” is … a very complex indicator … Keep It Simple, Stupid. (K.I.S.S) Yep. I’m being sarcastic. I’m also dead serious. No mention of stochastic oscillator in the book …
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This post is for the person who just has to know about stochastic oscillators. I know there are traders who use complex technical indicators. I’m even going to show you some charts with stochastics.
But you might be surprised. I won’t say “See, the stochastic oscillator gave me the indication that this stock was oversold so I bought.” Nope. If I did, it would completely lack integrity. (Because I don’t use them.)
Instead, I’m gonna show you a chart of a morning spike on a former runner, with a stochastic oscillator. It’s one I traded. It will become clear why this indicator just gets in the way.
I’m not saying you shouldn’t know this stuff. But it’s not what I do. So I’m going to take a contrarian view. Don’t be surprised if I tell you to stop focusing on stuff that doesn’t matter by the end of this post. Screw that — I’m gonna tell you now. Stop focusing on stuff that doesn’t matter.
Still reading? You just gotta know, don’t you? Okay. Here it is — the stochastic oscillator …
What Is a Stochastic Oscillator?
A stochastic oscillator (SO) is a technical indicator that compares a stock’s closing price to its trading range over a period of time. It’s represented as a number between 0 and 100. It’s most often shown in conjunction with a simple moving average of itself.
The standard number of periods for the stochastic oscillator is 14. For example, if you’re looking at a chart with daily candlesticks, the standard stochastic oscillator looks back over the last 14 days — SO(14). If your chart is 1-minute candlesticks, the stochastic oscillator is based on the last 14 minutes.
When the stochastic oscillator output is between 0 and 50, the stock closed in the lower half of its trading range. If the number is between 50 and 100, the stock closed in the upper half of its trading range. The closer to 0 and 100 respectively, the closer to the low or high in the trading range.
The stochastic oscillator is used as a way to determine momentum. It’s also used by traders to determine if a stock is overbought or oversold. It is commonly accepted that an SO number above 80 indicates a stock is overbought. An SO number below 20 indicates a stock is oversold.
The Stochastic Oscillator Formula
Here’s where it gets fun, right? I’m not that great at math. But I do know the formula for a stochastic oscillator. Let’s take a look …
Here’s the formula for a standard 14-day stochastic oscillator:
%K = 100 * (Close Price – L14)/(H14 – L14)
14 = the number of periods
So, L14 = the 14 period low. H14 = the 14 period high.
The reason for multiplying by 100 is to move the decimal place two positions.
Let’s look at an example using real numbers. Cool Company A closed at $4.00. The low over the last 14 days was $2.35 and the high was $4.87. Here’s the formula with those numbers plugged in:
100*(4 – 2.35)/(4.87 – 2.35) = 65.4762
Besides the above calculation, there’s a second plotted line, which is a simple moving average of the first. It’s normally represented as %D.
With each passing period, this is re-calculated and the two lines plotted. I’ll show you an example on a chart below. But first, because somebody asked and I’m such a nice guy …
How To Calculate the Stochastic Oscillator in Excel
Any charting or scanning software worth anything has stochastic oscillators built-in. Even freebies like Yahoo Finance have adjustable stochastics. You only have to click a few buttons and, voilà — there’s another line to keep you distracted from what you should be doing.
But somebody asked for an example. And that somebody might just turn into my next top student. Also, some people really love to see the numbers rather than the lines on the chart. There’s something to be said for that.
My top student, Tim Grittani, loves to use spreadsheets to track trades and gather data about possible setups. Check out the linked post. Tim has had an amazing journey and he was gracious enough to answer some questions. There’s even one there about spreadsheets.
I’m going to show you how to use Excel or even Google Sheets to set up a stochastic oscillator tracker. This is especially for you math geeks. (I’m not a math geek.) Love to spend more time inputting data than watching charts? Here you go …
First, take a look at the example spreadsheet based on DPW Holdings, Inc. This is only the fast stochastic using the first formula:
It’s important to note that it takes 14 days worth of data before there’s something to calculate. That’s why the spreadsheet doesn’t show 14-day highs/lows and closing prices prior to February 14.
If you download the file it can be opened in either Excel or Google Sheets. When you do that you’ll see how the stochastic oscillator formula is applied in the far right column. You can also see how to keep track of the high and low for your chosen period by using a simple MAX or MIN formula.
How do you figure this stuff out in Excel? Tim Grittani gave great advice at last year’s Trader and Investor Summit in Orlando. He said to invest in an Excel course on Udemy. There you go. He’s my top student for a reason. It’s good advice.
Scanning software like StocksToTrade automagically calculates stochastic oscillator (SO). So on the chart below, you’ll see SO data going further back in the chart than the spreadsheet example.
Here’s the daily chart for the same dates with the stochastic oscillator at the bottom:
DPW chart: daily candle, 14-day stochastic oscillator
The most important thing to get from the above chart? The stochastic oscillator isn’t giving much in the way of buy or sell signals. On February 8 it spiked up to 60. It’s generally accepted that anything above 80 is overbought and anything below 20 is oversold. Which makes the stochastic oscillator pretty much useless in this instance.
Pay attention because I’m about to share the chart at the time of my trade including what I was thinking and how it worked out. I’ve put the stochastic oscillator (both fast and slow — I’ll explain the difference later) on the chart for you to see.
Please note: I only put the stochastic oscillator on the chart below so you can see how it would look if I used it to trade. I don’t. It’s just another distraction to steal my attention from what I do … which is watch the chart.
DPW chart: 1-min candlestick; entry and exit plus stochastic oscillator
There are a few important things to notice on the chart above. Look at the pre-market trading — the paler area on the left. DPW hit a daily high of 0.14 on positive debt reduction news. Then there was some profit-taking heading into the market open. When the market opened, it spiked — briefly.
I’m a day trader. My whole thesis for this trade was based on the pre-market high and the positive news. The increase in volume pre-market meant there were a lot of traders paying attention. I thought it could climb close to the pre-market high on a morning spike. So I bought at $0.103 when upward price action was confirmed.
The spike was short lived and at the first sign of it being turned back I got out at $0.113. That’s a penny per share. Not what I was hoping for, but it was a win and a profit of $494.**
Here’s what I was NOT doing. I was NOT looking at the friggin’ stochastic oscillator. Which, by the way, said the stock was overbought for the entire time I was in the trade. It bounced between 0 and 100 over the course of the entire chart — even after trading volume dropped and the price action went flat.
I hope you get why using a stochastic oscillator doesn’t help me much.
I sometimes use Fibonnaci retracement as a confirmation of support and resistance. But even that would have been useless in this case because it was near zero. My point is this: Keep It Simple, Stupid. Here’s a list of 37 Stock Market Strategies. K.I.S.S. is #21.
I know there are haters out there saying “Sykes doesn’t know what he’s talking about.” Fine, go listen to what they have to say. When you’re done blowing up your account because you were paying attention to the stochastic oscillator when you should have been watching the chart … and managing your risk … come back and join the Trading Challenge.
Difference Between Stochastic Oscillator and RSI
The relative strength index (RSI) is another momentum indicator used to determine overbought and oversold conditions. It uses volatility rather than closing prices as a basis for calculation. RSI is available as a technical indicator on most stock screeners, including StocksToTrade. So I’m not going into the formula for RSI in this post.
Trending Versus Choppy Markets
One of the arguments against stochastics is they tend to be choppy. It can be difficult to get a read on what they mean. Of course, that’s because they measure momentum and not price. Plus, they’re backward looking. The takeaway here is, they appear to parallel price action better when there’s a clear trend in price.
Once you get into choppy price action, the stochastic starts making huge swings. Which is why there are different kinds of stochastics. The guy who developed stochastics for stock trading, Dr. George Lane, was aware of this. Using a simple moving average of the stochastic proved helpful in smoothing the data.
That’s why a stochastic oscillator is always shown as two plotted lines. Remember, %K is the stochastic and %D is the simple moving average of the stochastic.
Types of Stochastic Oscillator
There are three types of stochastic oscillator. It’s important to understand that the slow and full stochastic oscillators are derivatives of the fast stochastic. Ready? We’re on the home stretch now …
Fast Stochastic Oscillator
A fast stochastic oscillator is the line generated by using the formula above. In most charting software, if you apply fast stochastic oscillator to the chart you get the fast SO and the slow SO.
Slow Stochastic Oscillator
A slow stochastic is the simple moving average of the fast stochastic oscillator. It’s most common to use a 3-period SMA for a 14-period stochastic. In most charting software, when you apply slow stochastic you get the 3-period SMA of the fast stochastic and the 3-period SMA of the slow stochastic.
Full Stochastic Oscillator
The full stochastic oscillator adds one more layer of complexity. When a full stochastic oscillator is available on a chart, it is also fully customizable. You can set whatever periods suit you.
I’d rather trade the chart.
Take Advantage of StocksToTrade Features
The good news is, we’ve built stochastics into StocksToTrade. Along with about 40 other technical indicators. Why? Because everyone is different. I’ve never said my way is the only way. Only that I use what works for me and ignore the rest.
I have Trading Challenge students who use all sorts of indicators in their trading. That’s fine. If it serves you, use it. Just don’t let it get in your way. When you do that, it no longer serves its purpose.
Back to StocksToTrade. Full disclosure — I helped develop it. To my exact needs and specifications. Since it was released a couple years back we’ve added features. And it’s awesome.
From my favorite scans to custom scans, you can find stocks to meet whatever your trading criteria. Fast. You can set up multiple charts of a single stock for different time frames. You can watch several stocks at once either by using different tabs or multiple windows.
- Built-in Twitter feed. So you can see what other traders are pushing, bragging about, or hoping for. In other words, you can start to understand market psychology.
- Chat. 2 levels of chat depending on your subscription. Very cool feature. And if you have an STT Pro account you can hit-up lead trainer Tim Bohen in chat. He’s there during market open hours.
- The Basics Box. Why every other stock screener doesn’t have this is beyond me, but most don’t. Useful information all in one place: high, low, open, previous close, volume, 52-week high, and more.
I could go on but it’s best if you just hop on over to StocksToTrade and go for the 7-day trial. Then get a subscription and start using it. Simple. Remember, K.I.S.S. StocksToTrade will help with that.
Are you a trader? Do you use stochastic oscillators in your trading? Share your experience in the comments below. Even if you’re new to trading I’d love to hear from you!
The Stochastic Oscillator
About the Author: Andreas Thalassinos (BSc, MSc, MSTA, CFTe, MFTA), Head of Education at FXTM. Highly respected FX educator and Certified Technical Analyst and an authority in algorithmic trading.
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The Stochastic Oscillator is a very popular technical analysis tool, available on almost all trading platforms and used by many traders all over the world. It was developed by George Lane, a famous technical analyst, based on the premise that prices tend to close near the high of the candlestick during upward price movements, and near the lower end of the candlestick during downward movements. Similarly, the Stochastic determines where the price closed in relation to a specific price range over a chosen time period. During an uptrend prices tend to close near the top of a specific range, whereas during a downtrend they cluster near the bottom. The Scholastic Oscillator consists of two lines; %K and %D. Major signals are generated using %D.
Fast Stochastics Formula
The most popular periods for Stochastics are 5 and 14. During volatility the period of 5 or 9 is used, whereas the period of 14 is widely used for the rest of the markets.
Assuming a period of 5, a highest high of 30, a lowest low of 10 and a current close of 20, the formula above can be used the calculate the %K line:
The %K determines where the price closed in relation to a range (i.e. period) of candlesticks. For example, a reading above 80 implies that the current closing price is near the highest high of the range, which is in fact the highest price of the last 5 candlesticks. On the other hand, a reading below 20 puts the closing price near the lowest low of the range, which is in fact the lowest price of the last 5 candlesticks.
The second line, %D, is estimated by smoothing %K. Simply put, it is the 3-period simple moving average of %K:
This is known as a Fast Stochastic.
Fast Stochastics produce early signals, meaning that a further smoothing of the %K and %D lines is preferred by many traders.
By taking an additional 3-period Simple Moving Average of %D and %K, the corresponding Slow Stochastics are calculated as follows:
The Stochastic Oscillator ranges between 0 and 100. A reading of 0 means that the latest closing price is equal to the lowest price of the price range over the chosen time period.
A reading of 100 means that the latest closing price is equal to the highest price recorded for the price range over the chosen time period.
A reading above 80 is considered to be an indication that the market has reached extreme overbought levels, whereas a reading below 20 indicates that the market has declined to extreme oversold levels.
Buy and Sell Signals
A buy signal is generated when both %K and %D lines fall and cross over below the 20 oversold level. For further affirmative signals, traders may also wait for the %D line to rise above 20.
Conversely, a sell signal is generated when both %K and %D lines rise and cross above the overbought level of 80. Once again, if additional confirmation is required then traders wait for %D to fall below 80. It is worth noting that some traders wait for %K instead of %D to fall below the overbought level or rise above the oversold level to initiate an entry in the market. Similarly, for faster signals, traders watch the %K line instead of the slower %D line.
Apart from the 20 and 80 extreme levels, traders may also use the 30 and 70 levels at times. When trend-following indicators fail during sideways markets, the Stochastic Oscillator may produce timely signals.
Stochastics and Divergence
Apart from the oscillation of Stochastics between 0 and 100 and the crossing of the fast line, %K, and the slow line, %D, divergence may also by incorporated for signals.
A bearish divergence occurs when the slow line (%D) rises above 80 and forms two successively lower tops while the price rallies. Similarly, a bullish divergence occurs when both %K and %D fall below the oversold level of 20, and %D forms two successively higher bottoms while the price continues to decline.
Combination of Stochastics with RSI
Stochastics may also be combined with the popular Relative Strength Index (RSI) for potentially more precise signals and alerts.
For example, if the RSI is in the overbought area above 70, and %K and %D cross above 80, then this might produce an alert for an impending turning point on the price chart.
On the other hand, if the Stochastics cross below the 20 oversold level and the RSI is also below 30 then this might produce a bullish alert.
The Stochastic Oscillator is used by beginners and advanced traders alike. It is useful in both trending and ranging markets as it produces a varied range of signals. A crossover of the Stochastics above the overbought level or below the oversold level may be more common in a sideways market. On the other hand, a divergence (either positive or negative) between the oscillator and price may be more common during trending markets. It is wise to note that indicators and oscillators are better tools when they are combined with others, including, and especially, the price itself.
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How to Trade with Stochastic Oscillator
Using Slow Stochatics to Trade Talking Points:
- Slow Stochastic provides clear signals in a forex strategy
- Take only those signals from overbought or oversold levels
- Filter forex signals so you are taking only those in the direction of the trend
Stochastic is a simple momentum oscillator developed by George C. Lane in the late 1950’s. Be ing a momentum oscillator, Stochastic can help determine when a currency pair is overbought or oversold . Since the oscillator is over 50 years old, it has stood the test of time , which is a large reason why m any traders use it to this day.
Though there are multiple variations of Stochastic, today we’ll focus solely on Slow Stochastic.
Slow stochastic is found at the bottom of your chart and is made up of two moving averages. These moving averages are bound between 0 and 10 0. The blue line is the %K line and the red line is the %D line. Since %D is a moving average of %K , the red line will also lag or trail the blue line.
Traders are constantly looking for ways to catch new trends that are developing. Therefore, momentum oscillators can provide clues when the market ’ s momentum is slowing down, which often precede s a shift in trend. As a result, a trader using stochastic can see these shifts in trend o n the ir chart.
Learn Forex: Slow Stochastic Entry Signals
(Created by Jeremy Wagner)
Momentum shifts directions when these two Stochastic lines cross . Therefore, a trader takes a signal in the direction of the cross when the blue line crosses the red line.
As you can see from the picture above, the short term trends were detected by Stochastic. However, traders are always looking for ways to improve signals so they can be strengthened. There are two ways we can filter these trades to improve the strength of signal.
1 – Look for Crossovers at Extreme Levels
Naturally, a trader won’t want to take every signal that appears. Some signals are stronger than others. The first filter we can apply to the oscillator is taking cross overs that occur at extreme levels.
Learn Forex: Filtering Stochastic Entry Signals
(Created by Jeremy Wagner)
Since the oscillator is bound between 0 and 100, overbought is considered above the 80 level. On the other hand, oversold is considered below the 20 level. Therefore, cross downs that occur above 80 would indicate a potential shifting trend lower from overbought levels.
Likewise, a cross up that occurs below 20 would indicate a potential shifting trend higher from oversold levels.
2 – Filter Trades on Higher Time Frame in Trend’s Direction
The second filter we can look to add is a trend filter. If we find a very strong uptrend, the Stochastic oscillator is likely to remain in overbought levels for an extended period of time giving many false sell signals.
We would not want to sell a strong uptrend since more pips are available in the direction of the trend. (see “ 2 Benefits of Trend Trading ”)
Therefore, if we find a strong uptrend, we need to look for a dip or correction to time a buy entry. That means waiting for an intraday chart to correct and show oversold readings.
At that point, if Stochastic crosses up from oversold lev els, then the selling pressure and momentum is likely alleviated . This provides us a signal to buy which is in alignment with the larger trend.
A trader’s guide to the stochastic oscillator
The stochastic oscillator is a technical indicator that enables traders to identify the end of one trend and the beginning of another. Discover what the stochastic oscillator is and how to use it to predict market turning points.
What is the stochastic oscillator?
The stochastic oscillator is a momentum indicator, which compares the most recent closing price relative to the previous trading range over a certain period of time. Unlike other oscillators, it does not follow price or volume, but the speed and momentum of the market.
The stochastic oscillator was developed by George C. Lane in the late 1950s. His theory was based on the idea that market momentum will change direction much faster than volume or price increases. Therefore, the stochastic oscillator is considered a leading indicator, which means it can be used to predict price movements and inform traders’ decisions.
How to calculate the stochastic oscillator
The stochastic oscillator is formed of two lines on a price chart: the indicator line (%K) and a signal line (%D).
To calculate the signal line, a trader will need to subtract the lowest price over the period from the most recent closing price. They will then divide this by the highest price over the period minus the lowest price. The formula for the stochastic oscillator is as follows:
The stochastic oscillator line is normally plotted over a period of 14 days, while the signal line is a three-day simple moving average (SMA) of the %K.
Now, let’s look at an example of company XYZ’s share price. From the chart below, we can see that the 14-period low was $50, while the high was $80. XYZ’s stock closed very near the period high, at $78. So, the stochastic oscillator line would be calculated as follows: [(78-50)/(80-50) x 100] = 93.3%.
This figure indicates that the closing price was extremely near the top of the asset’s 14-period trading range – we’ll go onto what this means in a moment.
How to use the stochastic oscillator in trading
To use the stochastic oscillator, it is first important to understand exactly what the readings are showing you.
The stochastic oscillator is a bound oscillator, which means it operates on a scale of zero to 100 – this scale represents an asset’s entire trading range during the 14 days, and the final percentage shows where the most recent closing price sits within the range. This makes it easy to identify overbought and oversold signals. Regardless of how quickly the market price changes, or how the market volume fluctuates, the stochastic oscillator will always move in this range.
If there is a reading over 80, the market would be considered overbought, while a reading under 20 would be considered oversold conditions.
If we continue our previous example, a reading of 93.3% would be considered extremely overbought during the 14-day period. Following stochastic oscillator theory, this implies that a price reversal would be impending. In fact, some people believe that a reading above 90 is extremely risky and warrants the closing of positions.
As we have seen, the stochastic oscillator is shown as two lines on the chart, the %K (the black line on the chart below) and the %D (the red dotted line below). When these two lines cross, it is a sign that a change in market direction is approaching. If %K rises above %D, it would be a buying signal – unless the values are above 80. And if %K falls lower than %D, then it’s seen as a selling signal – unless the values are below 20.
Bullish and bearish divergences
The most common use of the stochastic oscillator is to identify bullish and bearish divergences – points at which the oscillator and market price show different signals – as these are normally indications that a reversal is imminent. A bullish divergence occurs when the price records a lower low, but the stochastic oscillator forms a higher low. This shows that there is less downward momentum and could indicate a bullish reversal. A bearish divergence forms when the market price reaches higher highs, but the stochastic oscillator forms a lower high – this indicates declining upward momentum and a bearish reversal.
However, it is always important to remember that overbought and oversold readings are not completely accurate indications of a reversal. The stochastic oscillator might show that the market is overbought, but the asset could remain in a strong uptrend if there is sustained buying pressure. This is often seen during market bubbles – periods of increased speculation that cause an asset’s price to reach consistently higher highs.
This is why it’s vital for anyone using the stochastic oscillator to combine the readings with other technical analysis indicators and a comprehensive risk management strategy.
Bull and bear set-ups
The founder of the stochastic oscillator, George Lane, believed that divergence could also be used to predict bottoms or tops. He called this a bull or bear set-up, as the indicator would reach a top or bottom which preceded the market changing direction.
A bull set-up is the opposite of a bullish divergence. It occurs when the market price forms a lower high, but the stochastic oscillator reaches a higher high. Even though the asset itself did not reach a new high, the optimism from the indicator is a sign that the upward momentum is strengthening.
A bear set-up is the inverse of a bearish divergence. It happens when the market price forms a higher low, but the stochastic oscillator falls to a lower low. Even though the asset held its price, the indicator shows there is increasing downward momentum.
Stochastic oscillator vs relative strength index
The stochastic oscillator and relative strength index (RSI) are both momentum oscillators, which are used to generate overbought and oversold signals.
Despite both being used for similar purposes, to identify price trends, they are based on very different theories. The stochastic oscillator is based on the idea that that closing prices will remain near historical closing prices, while the RSI tracks the speed of the trend.
Both oscillators work on a zero to 100 scale, but their signals also vary. The RSI would indicate the market is overbought if it reaches above 70, while the stochastic oscillator would need to reach 80. And the RSI would consider the underlying asset undersold if the indicator was below 30, while the stochastic oscillator would need to fall to 20.
Stochastic oscillator summed up
How you choose to use the stochastic oscillator will depend on your personal preferences, trading style and what you hope to achieve. However, there are a few key points that everyone who uses this momentum indicator should know:
- The stochastic oscillator is a momentum indicator, which compares the most recent closing price relative to the previous trading range over a certain period
- It is a leading indicator, as it’s based on the idea that market momentum will change direction must faster than volume or price increases
- The stochastic oscillator is formed of two lines on a price chart: the indicator itself (%K) and a signal line (%D)
- The stochastic oscillator is a bound oscillator, which means it operates on a scale of zero to 100. A reading over 80 is an indication the market is overbought, while a reading under 20 shows oversold conditions
- The most common use of the stochastic oscillator is to identify bullish and bearish divergences – points at which the oscillator and market price show different signals
- It can also be used to identify bull and bear set-ups, points that indicate increasing momentum in the opposite direction
- It is often likened to the relative strength index (RSI), another momentum indicator. However, the RSI is based on the speed of changing prices, rather than historical prices
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