Stochastic Oscillator Definition

Forex Trading

Stochastic Oscillator Definition



Adam Hayes, Ph.D., CFA, is a financial writer with 15+ years Wall Street experience as a derivatives trader. Besides his extensive derivative trading expertise, Adam is an expert in economics and behavioral finance. Adam received his master’s in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology.


The solid black line in the image below is called the %K and is determined by a specific formula , while the red dotted line is a 3-period moving average of the %K line. Traders should be aware that the stochastic indicator does have limitations. Another popular trading strategy using the stochastic indicator is a divergence strategy. In this strategy, traders will look to see if an instrument’s price is making new highs or lows, while the stochastic indicator isn’t.

Key Differences between the Stochastic RSI and Stochastic

In the provided example, the stochastic oscillator can be seen bouncing off of an area of resistance back in May 2018, staying under it until June 2019. However, once the resistance level was broken through on the stock chart, it later acted as support in July 2019. Once the stochastic made its way through it once again, the price level turned from support to resistance once again that the asset will need to break above to resume an uptrend. can utilize stochastic in several ways, primarily through watching for when trends turn into the other direction. Beyond this, understanding what the readings mean across the full range is the key to getting the most out of the stoch oscillator. Readings 80 or above suggest an uptrend is strong but may be ready to reverse, while readings below 20 could provide clues that a downtrend is coming to an abrupt end. Traders can observe the strength of a trend using the stochastic oscillator, identify when a trend may be turning, then use the information provided to determine if a trade should be entered. An oscillator, in stock market analysis, rises and falls between two set values.

For example, rather than using readings above 80 as the distinction line, they only interpret readings above 85 to signal overbought conditions. This signals that upward momentum has slowed, and a reversal downward may take hold. The failure of the oscillator to gain a new high alongside the instrument’s price action doing so signals that the momentum of the uptrend is beginning to weaken. The stochastic oscillator indicates the stability with which the price closes near its recent high or low by comparing the current price to the range over time. A reading of 80 indicates that the instrument is on the brink of being overbought. This two-line indicator can be entered into any chart and fluctuates between 0 and 100.

  • It is commonly accepted that an SO number above 80 indicates a stock is overbought.
  • In order to address this issue, Chande and Kroll designed the Stochastics RSI to increase sensitivity to the RSI and generate more overbought and oversold signals.
  • Here is a great video on YouTube from Investor Trading Academy that covers oscillators in general.
  • The term stochastic refers to the point of a current price in relation to its price range over a period of time.

If the stochastic changes direction and leaves the overbought or oversold area, it could be signaling a reversal. The fact is, there is nothing like overbought or oversold in the stochastic oscillator. However, the stochastic oscillator normally signals an uptrend above 80 or a downward continuation below 20. If your wish is to become an active trader, learning to predict the market with stochastic oscillator will come handy in identifying potential trades. Traders often use stochastic oscillator for the following purposes. Stock market, very few are as powerful as the stochastic oscillator.

Conversely, a buy occurs when an increasing %K line crosses above the %D line in the oversold region. The Slow Stochastic Oscillator is a momentum indicator that shows the location of the close relative to the high-low range over a set number of periods. The indicator can also be used to identify turns near support or resistance. Should a security trade near support with an oversold Stochastic Oscillator, look for a break above 20 to signal an upturn and successful support test. Conversely, should a security trade near resistance with an overbought Stochastic Oscillator, look for a break below 80 to signal a downturn and resistance failure. While momentum oscillators are best suited for trading ranges, they can also be used with securities that trend, provided the trend takes on a zigzag format.

This is when the trendline​​ of the stochastic and the trendline of the price move away from each other. This indicates that a price trend is weakening and may soon reverse. Readings above 50 indicate the instrument is trading within the upper portion of the trading range. Readings below 50 signal that the instrument is trading in the lower portion of the trading range.

Cite this Entry

The Stochastic Indicator is a widely utilized momentum indicator that helps traders to gauge the strength of the current market trend. It works by comparing the closing price of a security to its price range over a specific period of time, typically a number of bars on a chart. By plotting this information as a line on a separate oscillator, traders can easily identify overbought and oversold levels that may indicate a potential trend reversal. The stochastic indicator is a great tool for identifying overbought and oversold conditions over a specific time period.

Another option could be to look at both indicators and pinpoint when there is a divergence between the two. It’s really going to come down to what best fits your trading style. If you are the kind of trader that likes more signals, the Stochastic RSI will meet this need. In the above chart, notice how the stock continues to climb higher after each reading over 80. This is just a prime example of how you cannot blindly short just because the indicator is over 80. Now that we know how the Stochastic RSI and the stochastic oscillator works, here are the five key differences between the two oscillators.

stochastic oscillator definition

As with other oscillators, the Stochastics displays the location of the closing price relative to the high and low range over a specific period of time. The stochastic indicator is a two-line indicator that can be applied to any chart. The indicator shows how the current price compares to the highest and lowest price levels over a predetermined past period. The indicator works by focusing on the location of an instrument’s closing price in relation to the high-low range of the price over a set number of past periods. By comparing the closing price to previous price movements, the indicator attempts to predict price reversal points.

What Are Stochastics?

The second line (known as %D) is a simple moving average of the %K line. Now, as with most indicators, all of the periods used within Stochastic can be user defined. That being said, the most common choices are a 14 period %K and a 3 period SMA for %D. The stochastic technical indicator tells traders when the market is overbought or oversold. Lines are above 80 means the market is overbought and lines below 20 mean that the market is possibly oversold. Generally, it is best to buy when the market is oversold, and sell when the market is possibly overbought.

The price tends to be near to or at the lowest range of daily trading. A Bollinger Band® is a momentum indicator used in technical analysis that depicts two standard deviations above and below a simple moving average. The Kairi Relative Index is a technical analysis indicator used to indicate potential buy and sell points based on overbought or oversold conditions. In trading, the use of this term is meant to indicate that the current price of a security can be related to a range of possible outcomes, or relative to its price range over some time period. The stochastic indicator is classified as an oscillator, a term used in technical analysis to describe a tool that creates bands around some mean level. The idea is that price action will tend to be bound by the bands and revert to the mean over time.


This indicates that momentum is increasing and the instrument’s price could move higher. Traders often look to buy after a brief price pullback in which the stochastic indicator has dropped below 50 on the pullback and then moved higher again. A bear trade setup occurs when the stochastic indicator makes a lower low, but the instrument’s price makes a higher low. This signals that selling pressure is increasing and the instrument’s price could move lower. Traders often look to place a sell trade after a brief rebound in the price. When the stochastic %K line crosses the 80 line, the product is considered to be overbought.

The stochastic indicator helps traders identify trade exit and entry points by applying the overbought/oversold strategy. The primary limitation of the stochastic oscillator is that it has been known to produce false signals. This is when a trading signal is generated by the indicator, yet the price does not actually follow through, which can end up as a losing trade. During volatile market conditions, this can happen quite regularly. One way to help with this is to take the price trend as a filter, where signals are only taken if they are in the same direction as the trend.

When there’s a sustained period of uptrend or downtrend, the stochastic indicator can stay in the oversold or overbought area for a long period. One of the disadvantages of this oscillator is the possibility of false signals. It is the case when the share price does not follow the movement of the indicator. More precisely, the indicator gives a different signal from the price movement. The way to overcome this is to take into account the price trend.

Common Mistakes when using Stochastic Indicator

The ultimate oscillator has the advantage of being widely considered to be more accurate in monitoring divergences in market trends over different periods, compared to the stochastic oscillator. The ultimate oscillator is an indicator that was developed by Larry Williams in the mid-1970s to measure the pricing momentum of a stock or commodity via multiple time frames. Since then, it has been applied to other markets, as it tends to be less volatile and produce fewer signals, and therefore generates fewer whipsaws than many other similar indicators. A fast stochastic oscillator is the line generated by using the formula above.

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