When analyzing the price action of a tradeable asset over time on the charts, there are many important factors to assess before making a decision of whether to establish a bullish or bearish position. After first determining the period one wishes to trade within, it is important to comprehend the prevailing trend and if directional momentum is strong or weak alongside levels that indicate potential buying and selling pressure. One indicator that helps investors understand how momentum is shifting over time is the stochastic oscillator. Aside from giving useful insights into momentum and when it is on the verge of reversing in order to help identify entry and exit points for possible trades.
The stochastic oscillator measures compares the difference between a closing price during a period and the high and low price during the same period in an effort to understand the strength of momentum. Like most oscillators, this Stochastic oscillator fluctuates in range around a midpoint, typically denoted as the 50 level, which is used as a reference point for comparison between the upper bounds and lower bounds of the indicator. The total range between the top and bottom is 100, with 20 serving as the key level on the downside and the 80 level on the upside also of importance. These levels are used to help determine if momentum has sent an asset’s price into overbought or oversold territory.
Typically speaking, the Stochastic Oscillator is calculated based on the price action of the last 14 periods, using the high and low price over that time to define the range, with the stochastic referring to the distance between the close and the high/low prices during the period. Outside of the horizontal levels, there are two lines that help to generate signals referred to as the %K and %D. The %K line is calculated as follows:
%K = (Closing Price From Last Period – Low Price From Last 14 Periods) / (High Price From Last 14 Periods – Low Price From Last 14 Periods) * 100
The %D line is derived from the %K line value. Its value is equal to a 3-period simple moving average of the %K value. %D is particularly important because it is used to generate bullish or bearish signals depending on its position in the range. When above 80, it indicates the asset may be overbought whereas below 20, it suggests the asset may be oversold.
Stochastic Oscillator Application
Similar to a moving average crossover, when the %K line crosses over the %D line, it produces a signal when trending in the oversold territory between 0-20 and the overbought territory between 80-100. When the %K line crosses the %D line to the upside after trending below 20, it is a strong signal to establish bullish positions in an asset. Conversely, when the %K line crosses the %D line to the downside when trending above 80, it is a strong signal to establish bearish positions.
It is important not to just strictly focus on the Stochastic Oscillator, but also the prevailing trend when deciding between initiating bullish or bearish position. What this indicates, is that an overbought reading that produces a signal during a prevailing uptrend might not be as relevant a trade because it fights the trend and may not signal a reversal. The opposite is also true, with an oversold reading during a prevailing downtrend to be considered a less strong signal.
The Stochastic Oscillator is commonly applied in tandem with other indicators, such as Fibonacci Retracements, Elliot Waves, and other types of repeating cycles. The reason for this integration is to use the momentum properties combined with horizontal levels in order to give entry and exit signals and help identify reversal trading opportunities.