Stochastic Oscillators are a type of price momentum indicator. George Lane developed the first Stochastic Oscillator in the late 1920s as he sought to identify market trends and reversals.
He believed it is easier to spot a trend when prices stay within a relatively narrow range rather than constantly moving up and down through small fluctuations.
Stochastics consists of multiple lines calculated from underlying closing prices. The primary stochastic oscillator is composed of 2 lines.
One line represents the current closing price divided by the previous close (closing price divided by the previous period’s close).
Another is divided by the high less the low (current period’s high previous period’s Low).
George Lane also discovered that the crossover points between 0 and 100 of these two lines give a valuable indication of market entry and exit points.
In addition, the %K line crossing over or under the %D line provides an early indication of trend changes.
Lane believed that where prices fall rapidly in a bear market, they will bounce back quickly in a short “V-recovery” or rebound before falling again.
The speed of a trade signal is measured by looking at the difference between 2 consecutive closing price lines (i.e. [C] / [C-1] or [H] / [H-1]) – this is known as ‘Relative Strength’.
The faster the change in price, i.e. the greater the distance between lines, this is a stronger indicator.
A Stochastic Oscillator %K line has moved away from the %D line, indicating strength in the market. The opposite is true for when they move next to each other – this can signal a potentially oversold market or consolidation phase.
The further apart the two lines are, this indicates that there may be strong trend movements sooner rather than later. I.e. prices will continue falling until it reaches 0% and turn back up quickly (i.e. probably reversal).
The reverse would be for prices reflecting values around 100%.
The default setting for many charting packages shows both oscillators and their signals as histogram bars.
We can see how high values of %K (i.e. close/close -1) will give us an early indication of momentum and is represented by a green histogram bar on the bottom.
Whilst low values (i.e. close/close +1) are shown in blue to indicate low momentum or possibly bearish reversal condition.
Similarly, high values of %D (i.e. H-L or equity highs/lows) are shown in yellow, with low values in red. They would represent bearish reversals conditions with strong sell signals for both oscillator lines.
Most notably, when the faster %K line crosses below, the slower %D line, i.e. falls beneath it).
Bullish sign of flat
When both %K and %D are at their high values (i.e., close/close – 1), it is a vital bullish sign for markets.
The low relative strength lines reflect the tendency for prices to follow through in an uptrend without much interruption or convergence with other indicator indicators, which would then cause divergence in that case.
When the two lines are very close together, there is little difference between them, resulting in what investors refer to as “flat” markets when no movement is seen over several periods. There are no divergences or convergences, and the market is “flat”.
Identify oversold or overbought levels.
The most common use of stochastics is to identify oversold or overbought levels.
When the %K line moves down from above the %D line, it indicates a downward move in prices which may indicate a potential for a reversal in the uptrend trend, while when it moves up from below, this may signal an upward price movement which could continue if the momentum continues without any sign of divergence.
The caveat here is that both oscillator lines must be at their extremes (i.e., highest high and lowest Low) before a new movement can begin.
In other words, just because both %K and %D are at their extremes, it does not mean that prices must move in the opposite direction straight away.
Knowing how high/low values of these oscillators equate to actual price points becomes important. Stochastics may produce many false signals before they come good, provided you understand what the market is saying, i.e., whether it’s showing signs of strength or weakness!
A strong sell signal can be seen when both lines return to the “zero” line. It indicates potential for a reversal (or support) – this will indicate an influx of sellers who are now feeling bullish enough to take back control even though prices may still be relatively low depending on the timeframe used.