The Stochastic Oscillator is a popular momentum indicator used in technical analysis to assess the strength and direction of a market’s momentum. It was developed in the late 1950s by George Lane. The oscillator compares a particular closing price of a security to a range of its prices over a specific period. The idea is that in an uptrend, prices tend to close near their high, and in a downtrend, prices tend to close near their low.
Key Components:
- %K Line: The main line of the Stochastic Oscillator, representing the current close in relation to the range over a specific period.
- %D Line: A moving average of the %K line, often used as a signal line to identify potential buy or sell signals.
Calculation:
- %K = 100 × [(Current Close – Lowest Low) / (Highest High – Lowest Low)]
- %D = 3-period Simple Moving Average of %K
Interpretation:
- Overbought and Oversold Levels: The oscillator ranges from 0 to 100. Typically, readings above 80 indicate an overbought condition, suggesting a possible reversal downward, while readings below 20 indicate an oversold condition, suggesting a potential upward reversal.
- Crossovers: Buy or sell signals are often generated when the %K line crosses above or below the %D line.
- Divergence: A divergence between the oscillator and price action can signal an impending reversal. For example, if prices are making new highs but the oscillator fails to exceed its previous high, a bearish divergence is indicated.
Usage:
The Stochastic Oscillator is widely used in conjunction with other technical indicators to confirm trends, identify entry and exit points, and spot potential reversals. It is especially useful in markets that exhibit clear trends or cyclical patterns.