20/11/2019 Stochastic Oscillator Definition

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Stochastic Oscillator Definition

REVIEWED BY ADAM HAYES | Updated Jun 30, 2019

What Is A Stochastic Oscillator?

A stochastic oscillator is a momentum indicator comparing a particular closing price of a
security to a range of its prices over a certain period of time. The sensitivity of the oscillator
to market movements is reducible by adjusting that time period or by taking a moving
average of the result. It is used to generate overbought and oversold trading signals, utilizing
a 0-100 bounded range of values.

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20/11/2019 Stochastic Oscillator Definition
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KEY TAKEAWAYS
A stochastic oscillator is a popular technical indicator for generating overbought
and oversold signals.

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20/11/2019 Stochastic Oscillator Definition

It was developed in the 1950s and is still in wide use to this day.
Stochastic oscillators are sensitive to momentum rather than absolute price.

The Formula For The Stochastic Oscillator Is

C − L14
%K = ( ) × 100
H14 − L14
where:
C = The most recent closing price
L14 = The lowest price traded of the 14 previous
trading sessions
H14 = The highest price traded during the same
14-day period
%K = The current value of the stochastic indicator

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%K is referred to sometimes as the slow stochastic indicator. The "fast" stochastic indicator
is taken as %D = 3-period moving average of %K.

The general theory serving as the foundation for this indicator is that in a market trending
upward, prices will close near the high, and in a market trending downward, prices close
near the low. Transaction signals are created when the %K crosses through a three-period
moving average, which is called the %D.

Stochastic Oscillator

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What Does The Stochastic Oscillator Tell You?

The stochastic oscillator is range-bound, meaning it is always between 0 and 100. This
makes it a useful indicator of overbought and oversold conditions. Traditionally, readings
over 80 are considered in the overbought range, and readings under 20 are considered
oversold. However, these are not always indicative of impending reversal; very strong trends
can maintain overbought or oversold conditions for an extended period. Instead, traders
should look to changes in the stochastic oscillator for clues about future trend shifts.

Stochastic oscillator charting generally consists of two lines: one reflecting the actual value
of the oscillator for each session, and one reflecting its three-day simple moving average.
Because price is thought to follow momentum, intersection of these two lines is considered
to be a signal that a reversal may be in the works, as it indicates a large shift in momentum
from day to day.

Divergence between the stochastic oscillator and trending price action is also seen as an
important reversal signal. For example, when a bearish trend reaches a new lower low, but
the oscillator prints a higher low, it may be an indicator that bears are exhausting their
momentum and a bullish reversal is brewing.

The stochastic oscillator was developed in the late 1950s by George Lane. As designed by
Lane, the stochastic oscillator presents the location of the closing price of a stock in relation
to the high and low range of the price of a stock over a period of time, typically a 14-day
period. Lane, over the course of numerous interviews, has said that the stochastic oscillator
does not follow price or volume or anything similar. He indicates that the oscillator follows

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the speed or momentum of price. Lane also reveals in interviews that, as a rule, the
momentum or speed of the price of a stock changes before the price changes itself. In this
way, the stochastic oscillator can be used to foreshadow reversals when the indicator reveals
bullish or bearish divergences. This signal is the first, and arguably the most important,
trading signal Lane identified.

Example Of How To Use The Stochastic Oscillator

The stochastic oscillator is included in most charting tools and can be easily employed in
practice. The standard time period used is 14 days, though this can be adjusted to meet
specific analytical needs. The stochastic oscillator is calculated by subtracting the low for the
period from the current closing price, dividing by the total range for the period and
multiplying by 100. As a hypothetical example, if the 14-day high is $150, the low is $125 and
the current close is $145, then the reading for the current session would be: (145-125)/(150-
125)*100, or 80.

By comparing current price to the range over time, the stochastic oscillator reflects the
consistency with which price closes near its recent high or low. A reading of 80 would
indicate that the asset is on the verge of being overbought.

The Difference Between The Relative Strength Index (RSI) and The
Stochastic Oscillator
The relative strength index (RSI) and stochastic oscillator are both price momentum
oscillators that are widely used in technical analysis. While often used in tandem, they each
have different underlying theories and methods. The stochastic oscillator is predicated on
the assumption that closing prices should close near the same direction as the current trend.
Meanwhile, the RSI tracks overbought and oversold levels by measuring the velocity of price
movements. In other words, the RSI was designed to measure the speed of price
movements, while the stochastic oscillator formula works best in consistent trading ranges.

In general, the RSI is more useful during trending markets, and stochastics more so in
sideways or choppy markets.

Limitations Of The Stochastic Oscillator

The primary limitation of the stochastic oscillator is that it has been known to produce false
signals. This is when a trading signal is generated by the indicator, yet the price does not
actually follow through, which can end up as a losing trade. During volatile market
conditions this can happen quite regularly. One way to help with this is to take the price
trend as a filter, where signals are only taken if they are in the same direction as the trend.

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Related Terms
Williams %R Definition and Uses
Williams %R is a momentum indicator in technical analysis that measures overbought and oversold
levels. It is similar to the stochastic oscillator in how it generates trade signals. more

Dynamic Momentum Index Definition and Uses

The dynamic momentum index is used in technical analysis to determine if a security is overbought or
oversold. It can be used to generate trading signals in trending or ranging markets. more

Stochastic RSI - StochRSI Definition

The Stochastic RSI, or StochRSI, is a technical analysis indicator created by applying the Stochastic
oscillator formula to a set of relative strength index (RSI) values. Its primary function is to identify
overbought and oversold conditions. more

Relative Strength Index – RSI

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20/11/2019 Stochastic Oscillator Definition

The Relative Strength Index (RSI) is a momentum indicator that measures the magnitude of recent
price changes to analyze overbought or oversold conditions. more

Price Zone Oscillator

The Price Zone Oscillator plots a graph that shows whether or not the most recent closing price is
above or below the prior closing price. more

Ultimate Oscillator Definition and Strategies

The Ultimate Oscillator is a technical indicator developed by Larry Williams to measure the price
momentum of an asset across multiple timeframes. It produces buy and sell signals based on
divergence. more

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