Stochastic oscillators are a popular momentum indicator used in technical analysis and prized for their accuracy and clarity. They can provide overbought or oversold signals to traders and even be combined with other indicators, like moving averages or the Relative Strength Index (RSI), to unearth insights that support profit-maximizing trades.
Stochastics gauge an asset’s closing price in comparison to a range (measured 0-100) of closing prices over a mutable (though most often 14-day) time period, creating overbought (readings of 80-plus) and oversold (readings of 20 or under) trading signals.
The stochastic oscillator was developed in the 1950s by George Lane to analyze price movements and gauge the strength and speed of those movements. Lane compared stochastics to a rocket, explaining that “before [a rocket] can turn down, it must slow down. Momentum always changes direction before price.” This belief is rooted in the idea of highs and lows: that an asset’s closing price typically trades at the higher end of its daily price range in an upwards-trending market, while trading near its daily low during a downturn.
There are two types of momentum with stochastic indicators: ‘slow’ (indicated in formulas as %K, this is best at gauging wide trading ranges or slower trends) and ‘fast’ (shown in formulas as %D, this is a moving average of the ‘slow’ indicator). The crossover of these two values, when graphed, produces transaction signals.
Overbought and oversold readings will generally fall into the greater-than-80, less-than-20 range, respectively. Traders should not misinterpret these signals, however, as guarantees of an impending reversal – stronger trends can mean extended stretches of overbought or oversold behavior, making it pertinent for traders to closely examine the behavior of the stochastic oscillator to gain insight into potential shifts.
When the stochastic readings move above 60 or 80 (as seen in the chart below), it is an indication that the security has made a bearish crossover into overbought territory. When a trader sees that, he or she may consider selling the security or exploring put options or shorts. When the stochastic readers move below 20, it's considered a bullish crossover and a trader may see it as a signal to go long the security or explore call options.
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Divergences at lows or highs may indicate that the conditions may not have as much downside or upside momentum as the market might think and a reversal might be near. It can also help to determine overbought or oversold conditions.
No single indicator works well for all securities. Tickeron’s Artificial Intelligence, known as A.I.dvisor, is programmed to scan the stock, ETF, cryptocurrency, and FOREX markets in search of technical trading patterns. Once it discovers a pattern or a trend, it delivers the chart to subscribers in the form of “News,” which includes trade ideas and a trader’s odds of success – the kind of information needed to make rational, emotionless, and effective trades.