How Traders Can Use the Stochastic Oscillator

Comprehensive trading strategies require the use of diverse technical indicators. A combination of trend, volume and momentum indicators is popular among traders. The stochastic oscillator is a momentum indicator that signals the strength of the current trend to help traders make informed decisions.

Understanding Momentum Analysis

Momentum is the rate of change of an asset’s price in a given direction. If the momentum is strong, the price changes rapidly, indicating that market forces are likely to sustain the trend for longer. Conversely, weak momentum indicates an impending reversal.

Reversals are critical entry and exit points for traders. Traders who are riding the trend may want to exit before the trend reverses and those waiting for an opportunity to enter the market can do so as the trend direction reverses. Speculating reversals before they become apparent allows traders to refine their strategies and identify emerging trading opportunities.

Stochastic Oscillator

The stochastic oscillator compares the closing price of an asset using its price range over a specified period. It generates oversold and overbought signals for traders to identify reversals.

Calculating the Stochastic Oscillator

This indicator is plotted at the bottom of the chart in the form of two lines: %K and %D. These two lines together help traders to identify potential reversals by highlighting shifts in momentum.

%K calculates how the closing price correlates to the broader trend. It oscillates between 0 and 100.

%K = [(C – L14) / H14 -L14)] x 100

C = Closing price of the last day

L14 = Lowest price in the last 14 days

H14 = Highest price in the last 14 days

%D is the 3-day simple moving average of %K. 

Interpreting the Stochastic Oscillator Plot

The value of %K and the convergence and divergence of the two plot lines offer various insights to help traders make informed decisions.

Spotting reversals

Traders identify reversals when the value of %K is above or below certain thresholds:

Overbought Conditions

The value of %K above 80 is considered to indicate overbought conditions. This suggests that a price correction or reversal may take place. Traders may exit their long positions or enter short trades at this time.

Oversold Conditions

A value of %K below 20 indicates that the asset is oversold. The price is likely to bounce or undergo a bullish reversal in this case. Traders use this as a signal to exit short positions and go long.

Notably, oversold and overbought conditions do not usually indicate a reversal. Therefore, relying solely on these signals to make trading decisions might not always be helpful.

Trading Crossovers

When the %K and %D lines cross over, it generates a buy or sell signal:

• Bullish Crossover: When %K crosses over %D, it indicates a strong momentum driving the price higher. Traders use this to take long positions.
• Bearish Crossover: A bearish crossover occurs when %K crosses below %D, indicating a strong bearish momentum. This is a signal to sell or take short positions.

Identifying Divergence

Divergence occurs when the price line and momentum indicate different market directions.

Bullish Divergence

When the price makes lower lows and the %K makes higher lows during a downtrend, it is an indication of a bullish reversal. The weakening selling pressure is taken as a signal to switch the trading strategy for rising markets.

Bearish Divergence

A bearish divergence occurs when the price makes higher highs (indicating strength in the uptrend), and %K makes lower highs (indicating a weakness in the upward momentum). This scenario signals a reversal from an uptrend to a downtrend, and traders tend to exit their long positions or get ready to take short positions.

Limitations of the Stochastic Oscillator

The stochastic oscillator is often used in combination with other technical indicators because it has certain limitations, such as:

• It can generate false signals in highly volatile but trending markets.
• It is a lagging indicator. Therefore, traders use it as a confirmation signal rather than a standalone indicator.
• It does not provide clear exit signals.
• It is prone to whipsaws. For instance, it can generate a buy signal during temporary bottoms even in a downtrend. 
• A stochastic oscillator does not specify the direction of the trend, only the strength of momentum.

Combining the Stochastic Oscillator with Other Indicators

As no technical indicator is foolproof. Experienced traders popularly combine a few indicators to confirm signals and make better informed decisions. Combining technical indicators can strengthen the analysis and increase the accuracy of speculations.

The stochastic oscillator is used with support and resistance indicators, such as Bollinger Bands, RSI and Fibonacci levels. This helps identify breakouts above or below key levels to confirm a trend. Traders can adjust their strategies to take advantage of the opportunities that consequently arise. The stochastic indicator is used to confirm the trend or a reversal so that traders can open or close positions according to their trading strategies.

The stochastic oscillator can also be combined with price action indicators to take advantage of market opportunities. Traders combine it with candlestick patterns to confirm signals. For example, a morning star pattern during a downtrend, along with a %K below 20, indicates an impending bullish reversal. It is a signal for traders to go long. On the other hand, %K above 80 accompanied by an evening star is a signal to go short.

To Sum Up

• The stochastic oscillator is a momentum indicator.
• It is plotted in the form of two lines below the price chart.
• Traders use this technical indicator to identify trend reversals, continuation and oversold and overbought conditions.
• It is best to combine different types of indicators to improve the accuracy of technical analysis.
• Stochastic oscillators can be combined with range indicators and candlestick chart patterns.

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