The Stochastic Oscillator is a momentum oscillator used in technical analysis. It measures the momentum in price movements of a stock/asset/security. In simple terms, a stochastic oscillator compares the position of the most recent closing price of a stock with its highest and lowest trading prices during a given time frame.
The stochastic oscillator generates an overbought or oversold signal by comparing the latest closing price of the stock to a series of prices in a specified time frame. The overbought and oversold signals are valued between 0 to 100, with results above 80 indicating overbought and those below 20 implying oversold. Further, the stochastic oscillator helps in gauging trend reversals for the stock.
An oscillator is a device that works on the principle of oscillation, which represents a periodic fluctuation between two things based on changes in energy. Hence, a stochastic oscillator, too, tends to move around a mean price level as it studies the price momentum compared to a stock’s historical prices.
How is the Stochastic Oscillator Calculated?
The formula for the stochastic oscillator is quite simple to understand. By default, the setting for this indicator is 14 time periods (hourly, daily, monthly, etc.), with the 14-day period being a general norm.
Where C is the latest closing price
L14 is the lowest trading price in the prior 14 time periods
H14 is the highest trading price in the same 14 time periods
%K is the resultant current value of the stochastic oscillator
There is also another important parameter in the stochastic oscillator study; %D, which is a 3-day simple moving average of %K values. Notably, %K is called the fast indicator, and %D is the slow indicator.
How to Read the Stochastic Oscillator
Usually, during a market uptrend, a stock’s price will close near its highest trading price, and in a market downturn, it will close near its lowest trading price. A reading above 80 implies overbought and a reading below 20 implies oversold stock.
Notably, a Buy or Sell signal is generated when the %K line intersects the %D line. When the %K line crosses the %D line from below and goes above it, a bullish scenario is generated. On the other hand, when the %K line crosses the %D line from above and goes below it, a bearish scenario is created.
Interestingly, a stochastic oscillator is also used to read divergence, that is when a stock makes a new high or a new low reading. For instance, when the price of a stock makes a new high, but the stochastic oscillator does not follow suit, it indicates a bearish divergence. It can be read as a pending market reversal from an uptrend.
In the same vein, when the stock price makes a new low but the stochastic oscillator does not correspondingly move to a new low, it indicates a bullish divergence. It can be read as a reversal of the market from a downtrend to an uptrend. Importantly, the indicator may give a divergence signal some time before the price actually starts reversing. Hence, you may want to wait for some more signals of market reversal before taking a trading decision.
It is important to note that during a strong uptrend, stocks become overbought and remain there for extended times, implying sustained buying pressures. Similarly, during a strong downtrend, stocks become oversold and can remain there for extended times, implying sustained selling pressures. One must not confuse these as a signal of bearish or bullish markets. Instead, you can look for random overbought stocks during strong market downturns, and scan for random oversold stocks during strong market uptrends.
Limitation of the Stochastic Oscillator
One of the major shortcomings of using the stochastic oscillator by itself is that it may give false trading signals, particularly during turbulent times. It can be rightly used to study the strength or weakness of price movement in the market, and not for studying trends or direction. To reduce the possibility of false signals, some traders adjust the overbought and oversold range to 85 and 15. Having said that, these extreme ranges may remove the bias but also increase the chances of missing out on good opportunities to trade.
Working Example of Stochastic Oscillator
Let us see how the stochastic oscillator works with the live example of one of the most loved stocks, Apple (NASDAQ:AAPL). On TipRanks, you can visit the Chart section for a particular stock, and map the Stochastic Oscillator below the price chart to study the momentum, as we have shown below.
As seen from the chart above, the stochastic oscillator for AAPL moved into the overbought territories between October 21 and 26 in 2022, and more recently, between January 19 and 30 in 2023.
Similarly, AAPL moved into the oversold territories for a prolonged period of time between December 14, 2022, and January 5, 2023, and then again between February 22 and March 2, 2023.
On the TipRanks Chart, you can change the default 14-day range, as well as the overbought and oversold lines from 80 and 20 to adjust as per the stock’s historical price activity. This can be done by clicking on the settings icon next to the “stochastics (C,14,y,3,3)” icon on the chart. You can easily change the day range and the lines from this dropdown.
Key Takeaways
The stochastic oscillator can help you to understand trend reversals as well as to scan overbought and oversold levels in assets. However, the indicator can give misleading signals when used in isolation. It is always advisable to make buy/sell decisions by using a combination of technical indicators such as the Relative Strength Index indicator, coupled with your own judgment.
To learn more about the different technical indicators, visit TipRanks’ newly launched Technical Analysis tool. Now, go ahead and try the tools on TipRanks’ unique platform and power up your trades.
