Stochastic Oscillator

The Stochastic Oscillator is a popular oscillator that is widely used by traders to measure if a stock is “oversold” or “overbought”. Oscillators are most useful for stocks or indices that are trading sideways. Often a stock which is forming a base or a consolidation area, will change direction just as the stochastic reaches oversold or overbought. Oscillators are great trading tools for stocks trading in a range as well.

Developed by George Lane, this indicator measures the relationship between an issue's closing price and its price range over a predetermined period of time. The Stochastic Oscillator actually measures the price of a security relative to the high/low range over a set period of time, providing an indication of where the security is presently trading within its recent trading range. Today’s charting software does all the calculations, making the whole technical analysis process more accessible for the average investor or trader.

The Stochastic Oscillator is plotted on the chart below. The Stochastic Oscillator is plotted between the values of 0 and 100 and has reference lines placed at 20 and 80 as shown. The most simplistic use of stochastics involves two different moving averages that are comprised of a slow moving average and a fast moving average. When the fast average crosses above the slower moving average then a buy signal is generated. Conversely, when the faster moving average crosses below the slower moving average, then a sell signal is generated. In theory, the more volatile a market is, the greater the probability of getting a more reliable reading from the oscillator.

It is more reliably used when the stochastic crosses under the “20 line” and moves up above 20, generating a buy signal. Conversely when the Stochastic crosses above the 80 and moves below, a sell or “short” signal is generated. Another interpretation is that readings below 20 are considered “oversold” and readings above 80 are considered “overbought”. As such, this indicator lends itself well to positive/negative divergences. One final note on oscillators: Don't try to use an oscillating indicator by itself on a trending stock. It is a good way to get burned. Stocks in a downtrend can remain technically "oversold" (according to the stochastic) for literally weeks at a time. Stocks in a strong uptrend can max out the stochastic into "overbought" territory for weeks as well. Just look at large resource stocks during their bill run last year. They were technically in the oversold section for long periods of time, suggesting it could be time to short the stock. This would have been foolish.

The Stochastic Oscillator is a powerful technical tool, however, like all technical analysis, it is only useful if applied in the proper situation. Wait for the confirmation of the signal and combine it with other technical indicators or patterns to assist you in your entry decision.