Stochastic Oscillator Explained Definition & Examples

stochastic oscillator definition

Mark previously enjoyed 15 years as a stockbroker, and still maintains a strong interest in all things financial. He enjoys learning about the practical and theoretical side of investment, together with good old-fashioned gut instinct. Mark believes that keeping up with, and understanding the latest trends, is an important part of any investor’s arsenal – knowledge is everything. There is some debate as to the origins of the stochastic oscillator. However, George C. Lane is perhaps more commonly credited for his role in popularizing it.

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In other words, K represents the current price in relation to the asset’s recent price range. The stochastic oscillator represents recent prices on a scale of 0 to 100, with 0 representing the lower limits of the recent time period and 100 representing the upper limit. A stochastic indicator reading above 80 indicates that the asset is trading near the top of its range, and a reading below 20 shows that it is near the bottom of its range. The key to using the stochastic oscillator is finding the timespan that best suits your investment strategy. Those looking for short-term trades will focus on relatively short periods, prompting somewhat volatile swings in the indicator. Those looking for the confirmation of longer-term trends will extend the period in question.

What Are the Advantages of the Stochastic Oscillator?

Instead, traders should look to changes in the stochastic oscillator for clues about future trend shifts. Chart 3 shows Yahoo! (YHOO) with the Full Stochastic Oscillator (20,5,5). 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 2009 until April 2010.

Understand that whatever you choose, the more experience you have with the indicator will improve your recognition of reliable signals. Short-term market players tend to choose low settings for all variables because it gives them earlier signals in the highly competitive intraday market environment. Long-term market timers tend to choose high settings for all variables because the highly smoothed output only reacts to major changes in price action. The stochastic indicator establishes a range with values indexed between 0 and 100.

Market Volatility and Choppy Conditions

Then, you divide the total range for the period and multiply by 100. The stochastic oscillator calculates the strength or weakness of price action in a market, not the overall trend or direction. This scan starts with stocks that are trading above their 200-day moving average to focus on those that are in a bigger uptrend. Of these, the scan then looks for stocks with a Stochastic Oscillator that turned up from an oversold level (below 20). A trader could go long once %K (grey line) crosses %D (orange line) bottom-up (1). If they exit the market once the %K falls below %D, they would lose half of the potential income (2).

Mathematically, the two oscillators are nearly the same except that the slow stochastics %K is created by taking a three-period average of the fast stochastics %K. Taking a three-period moving average of each %K will result stochastic oscillator definition in the line that is used for a signal. A moving average is a great tool to use in conjunction with stochastics. It will act as a filter for your signals, as long as your trades are in the direction of the moving average.