The Stochastic Oscillator: The Best Momentum Indicator?


Day and short-term traders use technical indicators to analyze price movement for a short period, while long-term investors also employ the use of technical indicators to identify entry and exit points. There are two main types of technical indicators, which are:
  1. Oscillators: These are technical indicators that oscillate between a local minimum and maximum, they are plotted above or below a price chart. Examples include the Stochastic Oscillator, Moving Average Convergence Divergence (MACD), or Relative Strength Index (RSI).
  2. Overlays: These are technical indicators that use the same scale as prices and are plotted over the top of the prices on a stock chart. Examples include moving averages and Bollinger Bands.
The Stochastic Oscillator is an indicator that compares the position of a security's closing price relative to the highest and lowest prices during a specified period, typically a 14-day period. It gives readings that oscillate between zero and 100 to indicate the momentum of a security's price movement.

George Lane, a financial analyst, developed the stochastic oscillator in the late 1950s for use in the technical analysis of securities. He was one of the first researchers to publish research papers on the application of stochastic indicators and especially in comparison to the Elliott Wave Theory and Fibonacci Retracement. In addition to gauging the strength of price movement, the oscillator can also be used to predict market reversal turning points.

Stochastic Indicator Calculations

The Stochastic Oscillator is plotted as two lines: %K and %D.

%K = 100(C - L14)/ (H14 - L14)

Where:

C = the most recent closing price
L14 = the low of the 14 previous trading sessions
H14 = the highest price traded during the same 14-day period
%K= the current market rate for the currency pair
%D = 3-period moving average of %K

This formula works based on the assumption that closing prices are more important when it comes to predicting market conditions.

How to use the Stochastic Indicator

When the security price is making a new high or low that is not reflected on the Stochastic Oscillator, divergence occurs. It is worth noting that the Stochastic Oscillator may give a divergence signal sometime before price action changes direction.

For example, when the oscillator gives a signal of bearish divergence, the price may continue moving higher for several trading sessions before turning to the downside. The failure of the oscillator to reach a new high alongside price action indicates an impending market reversal from an uptrend to a downtrend. You can see an example below using Apple's ($AAPL) weekly chart, where the oscillator did not confirm the new highs.

Stochastic Indicator AAPL Stock Chart Divergence Bearish Bullish Example

Similarly, a bullish divergence occurs when the market price makes a new low but the oscillator does not move to a new low reading. Bullish divergence indicates a possible upcoming market reversal to the upside. This is the reason why it’s recommended to wait for some confirmation of a market reversal before entering a trading position. The 15-minute chart is the best time frame for day trading because it is not too fast and at the same time not too slow. Trading decisions should not be based on divergence only but in combination with other elements.


Overbought and Oversold Levels

Another use of the indicator is to identify overbought and oversold market levels. When the Stochastic Oscillator value goes above the reading of 80, we are in an overbought market condition, which indicates that if you already have a long position, you should start reducing your position size or look for opportunities to sell the underlying asset. Conversely, when the Stochastic Oscillator value goes below the 20 reading line, it is considered to be an oversold market condition, which shows that if you already have a short position, you should start reducing your position size or actively look for opportunities to buy the underlying asset

Stochastic Indicator Oscillator Stock Chart Example Overbought OverSold

Even though the overbought and oversold signals generated by the Stochastic Oscillator are quite reliable, it is important to note that these signals work best during a range-bound market. However, during an uptrend market, the Stochastic Oscillator becomes overbought, and during a downtrend market, the Stochastic Oscillator becomes oversold at a very fast rate and gives the illusion that the market is about to reverse.

Beginner day traders usually complain that they placed a buy or sell order during an uptrend or downtrend after seeing an overbought or oversold signal generated by the Stochastic Oscillator, which resulted in a loss.

These issues with the Oscillator are why reading technical indicators are much more of an art. Where experience and the use of other indicators and elements in combination will decrease the probability you will get a fake signal, thereby maximizing your profits.

Conclusion

When used optimally, the stochastic indicator can help you gauge price movements a lot better in both trending and range-bound markets. It is possible to develop a strategy that produces sound signals regardless of whether the market is in a trending or range-bound condition. Stochastic divergence is the most useful way to use the indicator because it can be used together with other indicators to eliminate losing trades and make entry signals more accurate.

I recommending back-testing the indicator, with as many charts as possible, and to observe it in real-time, and see if an edge can be added to your current trading system, or simply create one from the start with the Stochastic Oscillator.  

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