Stochastic Oscillator - What is Stochastic Indicator in Trading
Currently one of the massively used and popular momentum indicator used by many traders is the stochastic oscillator. The traders use it to identify the possible reversal points in the market. However, how popular it is most of the traders do not have a clear understanding of the indicator they use or even do not care to look at the indicators.
This article discusses the stochastic oscillator's uses, its history, and how it is calculated. It will help you understand the stochastic oscillator, and from there, you can start using it in your trade.
A stochastic oscillator is used to compare the most recent closing price of particular security with the lowest and the highest prices in a given period of time, showing us the strength of the trend and momentum. The stochastic oscillator readings oscillate from 0 and 100 in an approach to determine the momentum of that particular security.
The stochastic oscillator readings are usually the percentage expression of the trading range of the security in a specified period of time. The stochastic oscillator has 14 times oscillations either daily or per hour, but you can also modify it to meet your own needs and standards.
In the readings of 0 to 100, the 0 reading by default is used to represent the lowest trading range point while the 100 is used to represent the highest trading range.
How do you calculate the stochastic oscillator?
Calculating the stochastic oscillator is very easy, primarily if you use the following formula:
%K= (the difference between the closing price and the lowest price)/ (Difference between the highest price and the lowest price) * 100
%D = 3-day SMA of %K
In this formula, the closing price can be denoted by C, the lowest price refers to the lowest low for a specific period, and the highest high is the period's highest high.
How was the stochastic oscillator invented?
Sometimes it is not acceptable to use or apply some concepts and inventions without understanding their origin and history. If you have ever applied stochastic oscillator in your security analysis or conducted your research on the invention of stochastic oscillator, then must be aware of Dr George Lane.
The stochastic oscillator was invented in the late 1950s by Dr George lane with the main aim of implementing it in the securities technical analysis. Dr George Lane was a financial expert, and in history, he became the first person to publish research information concerning the stochastic oscillator.
According to Dr George Lane, the stochastic oscillator indicator could be used together with the Fibonacci retracement cycles or together with the Elliot wave theory for the purposes of achieving the profit or becoming successful.
During his research, Dr George Lane realized that the stochastic oscillator shows the momentum of the security price movement. This oscillator can be used to perform the comparison of the closing price position of the security and the maximum and minimum price range in a given period of time.
Dr George Lane also realized that the stochastic oscillator could be applied in the Trade market to predict or speculate the market reversal's turning points.
The 3 Applications of the stochastic oscillator
This section of the article discusses three applications of the stochastic oscillator in the Forex Trade.
⦁ Identification of Oversold and Overbought levels- The stochastic oscillator can be used to indicate the overbought and oversold levels in its 0 to 100 scale. When you find out that its reading is more than 80, automatically that is overbought level, on the other hand when the reading is less than 20, an oversold condition in the market is detected.
⦁ To Indicate Divergence
If the security price makes a new low or high and this change is not reflected in the stochastic oscillator, then a divergence results. In this situation, the price of the security moves to a new high or a new low, but the stochastic oscillator does not move correspondingly.
If the price moves high and the stochastic oscillator does not correspond then this situation is known as the bearish divergence. But, if the price moves low and the stochastic oscillator does not reflect, the situation is known as Bullish divergence.
You should note that the stochastic oscillator can be able to indicate the divergence signal even before the price goes high or low.
⦁ The Crossovers- the stochastic oscillator can also be used to show the crossovers. The crossovers are the points at which the slow stochastic line and the fast stochastic lines meet. From the formula of calculating the stochastic oscillator, the 0%K line represents the last line, and the %D is used to indicate the slow stochastic line.
If the %D and the 0%K lines meet and the %D goes above the 0%K then, this is referred to as a bullish situation and on the other and if the 0%K goes above the %D, then it is referred to as a Bearish situation.
The Limitations of the stochastic oscillator
One of the main drawbacks of the stochastic oscillator is its tendency to generate fake signals. This is a common scenario, especially during turbulent, high volatile trading conditions. For this reason, you are always advised to confirm the stochastic oscillator trading signals from other technical indicators.
Most of the traders aim to reduce the tendency of the stochastic oscillator to produce false indicators through the use of more extreme readings of the oscillator to show the oversold and the overbought market conditions.
In this scenario, these traders use the 85 reading to be the mark for indicting the overbought conditions. In contrast, the readings below 15 readings as the bearish .the adjustment of the 85/15 greatly reduces the number of the false signals hence achieving more accurate results.
One of the biggest problem and faults facing many traders is the misinterpretation of the oversold and the overbought. It is always essential to use the momentum indicators to identify the overbought and oversold in the market.
Most traders have popularly used the stochastic oscillator to identify the overbought and the oversold in the market, allowing the trader to come up with various trading strategies and allow enormous versatility during trading.
However, it is better to be cautious about the stochastic oscillator's indications since this indicator is prone to errors because it can generate false signals. As a trader, you should always be ready to use another technical indicator to identify the correct divergence, rather than trusting the stochastic oscillator alone because it can mislead you.
Student of Technical Analysis.