The Stochastic Indicator Oscillator, designed by George Lane, is a great leading indicator that provide accurate signal for short-term trading.
The assumption is that, in the course of an upward movement, closing prices tend to be close to the peaks recorded during the period considered.
While in a bearish market phase, closing prices tend to approach the lows recorded during that period.
According to this assumption, the Stochastic measures the strength of buyers and sellers.
If the market is within a stable bullish trend, buyers must be able to push up prices.
The closer the closing prices will be to the market peaks, the stronger the buyers will be.
Similarly, if the market is within a stable bearish trend, sellers must be able to push prices down.
The closer the closing prices will be to market lows, the stronger the sellers will be.
How to calculate the Stochastic Oscillator
The Oscillator consists of two lines, the % K and the % D.
The formula for calculating the line %K at 5 days is as follows:
%K = 100 × ((C – L5) / (H5 – L5))
- L5 is the lowest recorded minimum over the last five days.
- H5 the highest recorded during the same period.
The formula for calculating from line %D to 3 days is:
%D = 100 × (H3 / L3)
- H3 is the sum of the last three days of (C – L5).
- L3 is the sum of the last three days (H5 – L5).
%K and %D range from 0 to 100 points.
Values close to 100 indicate that the last closing price is close to the peaks of the observation period.
Values close to zero indicate that the last closing price is close to the lows of the period analyzed.
Stochastic Indicator – Standard Version
There is also a slower version of the two lines (Slow), whose trend is much more linear and less erratic.
In Slow Stochastic, there isn’t the line %K, replaced by the % D.
Calculating the 3-day moving average of the new line %K, you obtain the new line %D.
%K (slow) = is the 3-day moving average of % K
%D (slow) = is the 3-day moving average of %K(slow)
The oscillator, in both the Fast and Slow versions, is used to:
Identify situations of overbought or oversold.
It is necessary to highlight that values of %K greater than 80 points highlight a case of overbought.
Values less than 20 points, on the other hand, identify a state of overselling.
Provide up and down signals generated by the intersections of line %K with line %D.
When %K cuts from bottom to top %D, starting from its oversold area, we have a bullish signal.
When %K cuts from top to bottom %D, starting from its overbought area, we have a bearish signal.
How to Trade Divergences
If prices are in a bearish trend, we will look for positive divergences of %K or %D that can signal the exhaustion of the down-trend.
You must have decreasing price minimums, associated with increasing oscillator minimums drawn inside or near the oversold area.
Whereas in a bullish trend, you can detect some negative divergences of %K or %D.
These divergences are capable of signaling the exhaustion of the up-trend.
There must be an increasing price maximum associated with decreasing oscillator maximum, drawn within or close to the overbought area.
The Cyclical Behavior
We have seen that the Oscillator allows you to measure the upward and downward pressure on the market.
In particular, we have four recurrent situations:
When the market is in a negative trend, closing prices for individual days are often close lows today.
This situation confirms that downward pressure is intense, and sellers control the market.
In this phase, the Stochastic gradually loses value and, after falling below its equilibrium line (50 points), it moves inside the oversold area.
Secondly, sellers reduce their strength, and there is a strengthening of upward pressure.
It is the phase in which upward divergences can occur, which create the conditions for a recovery.
When the Stochastic is inside the oversold area, and there is a strengthening of the upward pressure, prices make a quick technical rebound.
The oscillator starts to rise, with the line %K crossing the % D from bottom to top and providing a long signal.
It begins an up-trend phase, with buyers providing strength signals.
The Market Trend
When the market is within a bullish trend, closing prices for individual days are often close to the day highs.
This condition confirms that upward pressure is intense, and buyers have control of the market.
In this phase, the Stochastic gradually rises in value and, after exceeding its equilibrium line (50 value), moves within the overbought area.
Secondly, the sellers reduce their strength, and there is a strengthening of the upward pressure.
It is the phase in which downward divergences can occur, which create the conditions for a subsequent bending.
When the Stoch is within the overbought area and downward pressure increases, prices are corrected.
The oscillator begins to descend, with the line %K crossing the % D from top to bottom and providing a bearish signal.
The market is entering a bearish phase, with sellers providing clear signs of strength.
Trading System with Stochastic Oscillator
The Oscillator is one of the most commonly used technical oscillators for traders operating on short and very short term horizons.
This indicator is very responsive in accepting market movements and providing timely operational signals.
The danger, however, is that it may provide too many signals and will not allow the primary trend on the market to be fully exploited.
In particular, when prices rise, the Stochastic quickly moves into the overbought area.
A brief correction is sufficient to turn it downwards and send a bearish signal that may be premature.
In this situation, therefore, the trading signal provided by the Stochastic could cause the closure of long positions in advance.
The indicator could also open up new short positions that would run counter to the up-trend on the market.
When prices drop sharply, the Stochastic moves quickly into the overselling area, in this case, a quick technical rebound is enough to send a bullish signal that could be premature.
In this situation, the trading signal provided by the Stochastic could cause the closure of any short positions in advance.
The indicator could also open up new long positions, which would run counter to the down-trend on the market.
Stochastic with other Indicators
The best use of the Stochastic is to combine it with other indicators.
In a trend following strategy:
A possible long-term strategy is to identify a strong bullish trend, confirmed by one or more directional indicators, for example, by the MACD.
After the prices have stretched and there aren’t negative divergences with the oscillators, a physiological correction (pullback) is expected that brings the Stoch within its overselling area.
When prices, after this short consolidation pause, resume their rise, the Stochastic will provide an interesting long signal, with the %K line crossing the % D from bottom to top.
On the contrary, a possible short strategy is to identify a bearish trend, confirmed by one or more directional indicators, for example, by the MACD.
After prices have fallen rapidly and there aren’t positive divergences with the oscillators, we expect a physiological technical rebound, which brings the Stochastic within its overbought area.
When prices, after this brief recovery, resume their decline, the Stochastic will provide an unusual downward (short) signal, with the %K line crossing from top to bottom the % D.
The signal is provided by the Stochastic Oscillator, which, after descending to its oversold area, turns upwards, with the % K crossing the % D from bottom to top.