Stochastic Oscillator

Introduction

Stochastic Oscillator was developed by George C. Lane in the late 1950s. This is a momentum indicator and used quite commonly for technical analysis. Here we will talk about the concepts behind Stochastic indicator, it's construction and stochastic trading strategies for trading decisions. Please note that the explanation if focused for Forex trading but it is equally valid for stocks or any commodity trading.

Overview

In a dynamically changing market it is required to know the current price action with respect to the price action pattern in the recent past. Stochastic oscillator helps us in doing that. It compares the current price with the highest and lowest prices during the selected time period and tells us where does the current price lies with reference to the lowest and highest prices.

Why knowing the current value with reference to the highest and lowest levels of the selected time period is important for trading Decisions?:

Its important to know the current market sentiment and trend in trading. Stochastic indicator does not associate directly with the price but with the momentum of the change in the price. It does not track the price action in the absolute terms but follows the rate of change in the prices. It is called an oscillator because it oscillates in a range of 0 to 100. 

Let's assume that we are analyzing the price data for past 2 weeks on a daily chart. If the recent daily closing prices are consistently near the highest value of past two weeks, it would indicate bullish sentiments. The opposite will be true i.e. bearish sentiments will be reflected if the recent daily closing is staying near the lowest price of the 2 weeks.

The Stochastic oscillator has two lines. The main line (called %K) and the trigger line (called %D). The main trading signals are generated when the main line crosses the trigger line upwards or downwards. Trading signals are also generated by over bought & over sold situations and divergences which are explained later.

Crossover Signals

Stochastic - example 1

The following chart shows stochastic on a trading platform:

Chart 1

Stochastic - example 2

Calculation and Construction

Let’s see how Stochastic is calculated and what are %K and %D.

The most common setting for Stochastic oscillator is 14 periods. Let's say we are considering daily chart then 1 period would mean 1 day. Let's say that the price action for the previous 14 days was as follows:

 

Time Period High -during the period Low- during the period Closing of the period
1 155.40 152.00 155.21
2 155.83 152.00 152.66
3 154.32 147.80 149.45
4 150.10 146.10 147.45
5 148.92 145.73 148.14
6 149.34 145.14 146.00
7 151.92 146.23 149.10
8 153.40 150.06 153.10
9 154.32 150.72 151.61
10 152.85 149.14 150.21
11 155.08 152.15 154.81
12 155.60 153.00 153.41
13 155.12 152.85 155.12
14 155.45 150.76 151.41

In the above example the most recent closing is 151.41, the lowest during the 14 days was 145.14 and the highest during the past 14 days was 155.83.

The following formulas show how %K and %D are calculated:

%K = 100 X ( Current Close (n) - Lowest (n) )
Highest Price (n) - Lowest (n)

Here (n) is the selected number of periods, which in our case is 14 periods i.e. 14 days on daily chart. If we are using an hourly chart then 14 periods would mean 14 hours.

%D 3 Period Moving Average of %K

Hence considering the price table above % K would be:

%k 100 X ( 151.41-145.14 ) = 58.65%
155.83 - 145.14

Summary of %K and %D:

%K:
%K indicates the relative position of current closing with reference to the highest and lowest prices of the selected period of time.

%D:
The %D line is obtained by connecting the SMA (Simple Moving Average) points of the relative position i.e. %K for previous 3 periods.

Hence what we are checking is where the current relative position i.e. %K stands against it's own moving average of past 3 days i.e. %D.

Further explanation:

Let's try to walk through the explanation in simple points to make it easier to understand. For the following point lets consider the standard period settings which is 14 period and 3 i.e. we are analyzing 14 periods' data for %K and %D is past 3 days' moving average of %K. 

  1. Stochastic i.e. %D line oscillates between 0 and 100. 
  2. %D is the simple moving average of past 3 periods of the closing values of %K.
  3. If %K is above 50 then it would mean that the current closing prices are staying closer to the highest price of past 14 periods. If it is staying below 50 then it would mean the the current closing prices are near the lowest of 14 periods.
  4. If %K line is above %D then it would mean that the recent momentum is positive. On the other hand if %K is staying below %D then it would mean that the recent momentum is negative.
  5. When %K and %D lines are in the range of 50 to 100 and %K is over %D line, it indicates that the positive momentum is gaining. In the same range if %K drops below %D line then it would mean that the positive momentum is slowing down or reversing.
  6. When %K and %D lines are in the range of 0 to 50 and %K is below %D line, it indicates that the negative momentum is gaining. In the same range if %K moves above %D line then it would mean that the negative  momentum is slowing down or reversing.

Types of Stochastic Oscillator

There are 3 different types Stochastic oscillator. These types came into existence in order to optimize the frequency of signal generation to avoid false signals. These types are as follows:

  1. Fast stochastic
  2. Slow Stochastic
  3. Full Stochastic

Out of these 3 types, the one explained on this page is the original stochastic indicator which is also knows as fast. The number of signals generated by it are highest and hence the percentage of false signals or not very good signals is high. The other two types can be seen by clicking on the hyperlinks.

Trading Signals And Strategies

Stochastic signals can be interpreted in the following ways:

    1. Over bought / Over sold situation
    2. Crossover (the Stochastic line crossing the Trigger line)
    3. Divergence

Stochastic indicator is an oscillator. It moves between “0” and “100”.

Overbought And Oversold situation

Readings below 20 are considered oversold situation and indicate that it may be the time to buy as the currency pair might have already been oversold. Readings above 80 are considered to be overbought and indicate that it may be the time to short-sell as the currency pair might have already been overbought.

However, level above 80 does not necessarily mean that people will not buy further and a reading below 20 cannot conclude that people will not sell further. The market may continue to rise after the Stochastic Oscillator has reached 80 or crossed over 80 and continue to fall after the Stochastic main line has reached 20 or gone below 20. The overbought and oversold situation are just indications that sooner or later a reversal may come. Taking positions only on the basis that Stochastic has moved over 80 and hence prices would come down or because Stochastic has gone below 20 and hence market would start going up is never a good idea as trends may continue for a long time. Avoid taking actions only based on such observations.

Crossover Signals

Bullish and bearish signals are generated when %K moves over or below %D, respectively.

When %K line moves over the %D line, it signals that the upward momentum is increasing and the prices may move up further. Such a crossover gives us a “Buy” signal. Please note that the “Buy” signal by the crossover is more authentic when the Stochastic is near or below 20 (oversold region). Avoid using this “Buy” signal when it is near 80 or above 80 (overbought zone).

When %K line moves below the %D line, it signals that the downward momentum is catching up and prices may move down further. Such a crossover gives us a “Sell” signal. Please note that that the “Sell” signal by the crossover is more authentic when the Stochastic is near or above 80 (overbought zone). Avoid using this “Sell” signal when it is near 20 or below 20 (oversold region).

Chart 2

Stochastic - example 4

Explanation of above Forex chart

The above chart is of EUR/USD with Stochastic oscillator. Let's analyze various situations as follows:

Point A: The %K line moves below %D line in the overbought region i.e. when it is in the range of 80 to 100.

The price at point “A” was approx 1.5800 .The prices moved up slightly after this bearish crossover but then, subsequently, went down towards 1.5600. This signal resulted in nearly 200 pips from the crossover point. Please note that after a crossover the price may move in the opposite direction for some time before moving back to the direction pointed out by the signal. Hence it is always advisable to put a limit buy or sell order at few pips below or above, respectively, where the cross over takes place.

Point X (corresponding price approximately 1.5700)

Stochastic was near 40 i.e. in the bearish zone but above the oversold region. At point X the %K line moved over the %D line. This signalled an upward movement and that’s what exactly happened. The market moved up approximately 100 pips i.e. from close to 1.5800 to nearly 1.5900.

Point B: %K line moved below the %D line. This signal was a bearish signal and though the downward move took place but it was not substantial. 

Next crossover at unnamed point after point B: The %K line moved over %D line. This was a bullish signal but it proved to be a false signal. The important point to be noted here is that the Stochastic was around 60 and though it was not in the overbought region but was closer to that region. As mentioned about that a bullish crossover signal near the oversold region is always better.

Point C: %K moved below %D line again. Even though the Stochastic main line was not in the overbought region, there was a strong fall. Now if we really ignore the unnamed crossover point between point "B" and point "C" then this strong fall basically relates to the bearish signal at point "B".

A very important point to be noted here is divergence shown by point A, B and C. Divergences may prove to be the best trading signals and will be explained under the next heading.

Stochastic Oscillator And Divergences

For the most reliable trading signals, wait for a divergence to develop from overbought or oversold levels. 

Once the oscillator reaches overbought levels, wait for a negative divergence to develop and also wait for a move below the 80 level. It's better not to sell at the first dip below 80 but wait to see sustains below 80 for some time. Most of the time it would bounce back over 80 after the first dip. The second dip results in the sell signal. 

For a buy signal, wait for a positive divergence to develop after the indicator moves above 20. It is better to disregard the first break above 20. After a positive divergence forms, the second break above 20 confirms the divergence and this is a better time to enter a long position.

Positive And Negative Divergences

Stochastic - example 5

Chart 3

Stochastic - example 6

In the above chart point A was closer to the peak in the overbought region. The %K (main line) line went below %D line (trigger line) at point A and then climbed again before going down further from the 2nd bearish crossover at point B. The peak near point B was lower than point A. next peak at point C was lower than peak at Point B. And see what happened. When the %K line crossed %D line downwards near point C, the fall was really strong.

Take a note of such divergences when the subsequent high or low points (peaks and valleys) are going lower than the previous peaks. It may give a good signal for an emerging downtrend. Similarly if the subsequent high and low points (peaks and valleys) are going higher than the previous ones, it may give a good signal for an emerging uptrend.

Chart 4

Stochastic - example 7

In the chart shown above, please note that after the bullish crossover at point P, the price moved higher as the signal had indicated. Point Q was practically a false signal because the crossover took place neither in the overbought nor in the oversold region. Crossover at point R signalled short selling. The bullish crossover at point S proved to be a very good signal. The price went up very strongly. Note that the lowest point at S was higher than the previous lowest point at P. This was a case of divergence. Hence at point P we got two signals from stochastic oscillator, one from crossover and another by the divergence.

The following chart is for practice by analyzing different crossover scenarios as explained above.

Stochastic oscillator - chart 5

Stochastic - example 8

Check Stochastic with ADX and Bollinger Bands
Stochastic with ADX, SAR, RSI and MACD

We explained Stochastic Oscillator in the context of "Forex Trading" but the same stands good for stock trading or any commodity trading.

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