The Stochastic Oscillator: Understanding & Application
The Stochastic Oscillator is a momentum indicator that measures the relationship between a specific closing price and its price range over a defined period. Developed by George Lane in the 1950s, it's a tool designed to pinpoint reversals by identifying overbought and oversold conditions.
How the Stochastic Oscillator Works:
The oscillator ranges between 0 and 100 and typically uses a 14-day period as its default setting. The formula to calculate the %K (main line) is:
%K = [(Current Close - Lowest Low) / (Highest High - Lowest Low)] x 100
A 3-day simple moving average of %K produces the %D line, which acts as a signal line.
Interpreting the Stochastic Oscillator:
- Overbought & Oversold: A reading above 80 is considered overbought, while a reading below 20 is seen as oversold. This means the price is considered high or low compared to its recent trading range.
- Signal Line: When the %K crosses above the %D, it's a potential buy signal, and when it crosses below, it's a potential sell signal.
Example:
Let's say over a 14-day period for a specific stock:
- Current Close: $105
- Lowest Low: $100
- Highest High: $110
Using the formula:
%K = [(105 - 100) / (110 - 100)] x 100 = 50%
If our %D (3-day SMA of %K) is at 40%, and the %K crosses above it, this could be seen as a potential buy signal, assuming the stock isn't in an overbought condition.
It's crucial to understand that the Stochastic Oscillator, like other technical indicators, is best used in conjunction with other tools and should not be relied upon by itself. Also, practice and experience will help in mastering its use.