Developed by George C. Lane in the late s, the Stochastic Oscillator is a momentum indicator that shows the location of the close relative to the high-low range over a set number of periods. It follows the speed or the momentum of price.
As a rule, the momentum changes direction before price. This was the first, and most important, signal that Lane identified. Lane also used this oscillator to identify bull and bear set-ups to anticipate a future reversal. Because the Stochastic Oscillator is range bound, is also useful for identifying overbought and oversold levels. The default setting for the Stochastic Oscillator is 14 periods, which can be days, weeks, months or an intraday timeframe.
Click here to download this spreadsheet example. The Stochastic Oscillator measures the level of the close relative to the high-low range over a given period of time. Assume that the highest high equals , the lowest low equals and the close equals The close less the lowest low equals 8, which is the numerator.
The Stochastic Oscillator is above 50 when the close is in the upper half of the range and below 50 when the close is in the lower half. Low readings below 20 indicate that price is near its low for the given time period. High readings above 80 indicate that price is near its high for the given time period.
The IBM example above shows three day ranges yellow areas with the closing price at the end of the period red dotted line. The Stochastic Oscillator equals 91 when the close was at the top of the range. The Stochastic Oscillator equals 15 when the close was near the bottom of the range. The close equals 57 when the close was in the middle of the range. There are three versions of the Stochastic Oscillator available on SharpCharts. The default parameters were used in these examples: As a bound oscillator , the Stochastic Oscillator makes it easy to identify overbought and oversold levels.
The oscillator ranges from zero to one hundred. No matter how fast a security advances or declines, the Stochastic Oscillator will always fluctuate within this range. Traditional settings use 80 as the overbought threshold and 20 as the oversold threshold. These levels can be adjusted to suit analytical needs and security characteristics. Readings above 80 for the day Stochastic Oscillator would indicate that the underlying security was trading near the top of its day high-low range. Readings below 20 occur when a security is trading at the low end of its high-low range.
Before looking at some chart examples, it is important to note that overbought readings are not necessarily bearish. Securities can become overbought and remain overbought during a strong uptrend. Closing levels that are consistently near the top of the range indicate sustained buying pressure. In a similar vein, oversold readings are not necessarily bullish. Securities can also become oversold and remain oversold during a strong downtrend.
Closing levels consistently near the bottom of the range indicate sustained selling pressure. It is, therefore, important to identify the bigger trend and trade in the direction of this trend.
Look for occasional oversold readings in an uptrend and ignore frequent overbought readings. Similarly, look for occasional overbought readings in a strong downtrend and ignore frequent oversold readings. Chart 3 shows Yahoo!
A longer look-back period 20 days versus 14 and longer moving averages for smoothing 5 versus 3 produce a less sensitive oscillator with fewer signals.
Yahoo was trading between 14 and 18 from July until April Such trading ranges are well suited for the Stochastic Oscillator. Dips below 20 warn of oversold conditions that could foreshadow a bounce. Moves above 80 warn of overbought conditions that could foreshadow a decline. Notice how the oscillator can move above 80 and remain above 80 orange highlights. Similarly, the oscillator moved below 20 and sometimes remained below The indicator is both overbought AND strong when above A subsequent move below 80 is needed to signal some sort of reversal or failure at resistance red dotted lines.
Conversely, the oscillator is both oversold and weak when below A move above 20 is needed to show an actual upturn and successful support test green dotted lines. The Full Stochastic Oscillator 20,5,5 was used to identify oversold readings. Overbought readings were ignored because the bigger trend was up. Trading in the direction of the bigger trend improves the odds. Subsequent moves back above 20 signaled an upturn in prices green dotted line and continuation of the bigger uptrend.
With a downtrend in force, the Full Stochastic Oscillator 10,3,3 was used to identify overbought readings to foreshadow a potential reversal. Oversold readings were ignored because of the bigger downtrend. The shorter look-back period 10 versus 14 increases the sensitivity of the oscillator for more overbought readings. For reference, the Full Stochastic Oscillator 20,5,5 is also shown.
Notice that this less sensitive version did not become overbought in August, September, and October. It is sometimes necessary to increase sensitivity to generate signals. Divergences form when a new high or low in price is not confirmed by the Stochastic Oscillator. A bullish divergence forms when price records a lower low, but the Stochastic Oscillator forms a higher low.
This shows less downside momentum that could foreshadow a bullish reversal. A bearish divergence forms when price records a higher high, but the Stochastic Oscillator forms a lower high. This shows less upside momentum that could foreshadow a bearish reversal. Once a divergence takes hold, chartists should look for a confirmation to signal an actual reversal. A bearish divergence can be confirmed with a support break on the price chart or a Stochastic Oscillator break below 50, which is the centerline.
A bullish divergence can be confirmed with a resistance break on the price chart or a Stochastic Oscillator break above The Stochastic Oscillator moves between zero and one hundred, which makes 50 the centerline. Think of it as the yard line in football. The offense has a higher chance of scoring when it crosses the yard line. The defense has an edge as long as it prevents the offense from crossing the yard line. A Stochastic Oscillator cross above 50 signals that prices are trading in the upper half of their high-low range for the given look-back period.
This suggests that the cup is half full. Conversely, a cross below 50 means that prices are trading in the bottom half of the given look-back period. This suggests that the cup is half empty. Notice how the stock moved to a new low, but the Stochastic Oscillator formed a higher low. There are three steps to confirming this higher low. This provides the earliest entry possible. The second is a move above 50, which puts prices in the upper half of the Stochastic range.
The third is a resistance breakout on the price chart. Notice how the Stochastic Oscillator moved above 50 in late March and remained above 50 until late May. The stock moved to higher highs in early and late April, but the Stochastic Oscillator peaked in late March and formed lower highs. The signal line crosses and moves below 80 did not provide good early signals in this case because KSS kept moving higher.
The Stochastic Oscillator moved below 50 for the second signal and the stock broke support for the third signal. As KSS shows, early signals are not always clean and simple. Signal line crosses, moves below 80, and moves above 20 are frequent and prone to whipsaw.
Even after KSS broke support and the Stochastic Oscillator moved below 50, the stock bounced back above 57 and the Stochastic Oscillator bounced back above 50 before the stock continued sharply lower. George Lane identified another form of divergence to predict bottoms or tops. A bull set-up is basically the inverse of a bullish divergence.
The underlying security forms a lower high, but the Stochastic Oscillator forms a higher high. Even though the stock could not exceed its prior high, the higher high in the Stochastic Oscillator shows strengthening upside momentum. The next decline is then expected to result in a tradable bottom. The stock formed a lower high as the Stochastic Oscillator forged a higher high. This higher high shows strength in upside momentum.
Remember that this is a set-up, not a signal. The set-up foreshadows a tradable low in the near future. Traders could have acted when the Stochastic Oscillator moved above its signal line, above 20 or above Alternatively, NTAP subsequently broke resistance with a strong move.
A bear set-up occurs when the security forms a higher low, but the Stochastic Oscillator forms a lower low.More...