How Do I Read and Interpret a Stochastic Oscillator?

stochastic oscillator definition

If followed naively, the choppiness of the fast indicator can lead to increased transaction costs due to the many trading signals. The signals generated may not be as strong, and there might be losses due to an incorrect decision. If the stock price has fallen further, but the %K rises, then it is a reversal in the trend. According to the stochastic oscillator analysis, it is a buy signal, and the trader should place a buy order. The stock is sold when the oscillator crosses 80, and a sell signal is generated. Meanwhile, the RSI tracks overbought and oversold levels by measuring the velocity of price movements.

stochastic oscillator definition

This shows less downside momentum that could foreshadow a bullish reversal. A bearish divergence forms when price records a higher high, but the Stochastic Oscillator forms a lower high. This shows less upside momentum that could foreshadow a bearish reversal. Once a divergence takes hold, chartists should look for a confirmation to signal an actual reversal. A bearish divergence can be confirmed with a support break on the price chart or a Stochastic Oscillator break below 50, which is the centerline.

Stochastic Oscillator vs. Stochastic Momentum Index

The stochastic oscillator is calculated by subtracting the low for the period from the current closing price, dividing by the total range for the period, and multiplying by 100. Overbought and oversold conditions mean that the security price is near the top of its trading range and potentially overbought or near the bottom and possibly oversold in any specified period. These overextended levels enable savvy traders to buy or sell the trading ranges.

The SMI, on the other hand, shows the closing momentum relative to the median high or low range for a particular period. They then interpret the above 85 to indicate overbought conditions, and those below 15 suggest oversold conditions. In other words, its output is two steps away from the actual price of the asset being analyzed, which means at times it may be out of sync with an asset’s market price in real time. The word stochastic is used to describe other terms and objects in mathematics. Traders also use the SMI as a general trend indicator, interpreting values above 40 as indicative of a bullish trend and negative values greater than -40 as showing a bearish trend.

How Do I Read and Interpret a Stochastic Oscillator?

Notice that this less sensitive version did not become overbought in August, September, and October. It is sometimes necessary to increase sensitivity to generate signals. 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. As you can see from the picture above, the short term trends were detected by Stochastic. However, traders can look to strengthen the signal in a number of ways, two of which we’ll look at below.

It is an unprofitable strategy in the long run, but the chart reveals something interesting. The short portion of the strategy is effective at making money during a drawdown. It is further supported by the fact the indicator generates more sell signals than by signals. The signals can be used to create a dedicated long or short strategy, as well as a long-short strategy. In our strategy, the buy signal is generated when the %K falls below 20, and a sell signal is triggered when the %K rises above 80.

George Lane’s Strategy

The indicator moves between 0 and 100 to indicate the momentum of the security. They seem similar, but the StochRSI relies on a different formula from what generates RSI values. Meanwhile, StochRSI is derivative of RSI itself, or a second derivative of price. StochRSI moves very quickly from overbought to oversold, or vice versa, while the RSI is a much slower moving indicator. One isn’t better than the other, StochRSI just moves more (and more quickly) than the RSI.

Notice how the oscillator can move above 80 and remain above 80 (orange highlights). Similarly, the oscillator moved below 20 and sometimes remained below 20. A subsequent move below 80 is needed to signal some sort of reversal or failure at resistance (red dotted lines). A move above 20 is needed to show an actual upturn and successful support test (green dotted lines). A %K result of 80 is interpreted to mean that the price of the security closed above 80% of all prior closing prices that have occurred over the past 14 days. The main assumption is that a security’s price will trade at the top of the range in a major uptrend.

Although the two tools are not surefire ways to determine price direction, they can offer key insights into public opinion regarding a stock, ETF, or sector. The stochastic oscillator definition main shortcoming of the oscillator is its tendency to generate false signals. They are especially common during turbulent, highly volatile trading conditions.

  • Taking a three-period moving average of each %K will result in the line that is used for a signal.
  • Almost all traders use at least one of the tools, but they differ in that the oscillator is a simpler tool and considers the closing price of a given period, such as a day or week.
  • Notice how the oscillator can move above 80 and remain above 80 (orange highlights).
  • Close inspection will reveal that the %K of the slow stochastic is the same as the %D (signal line) on the fast stochastic.
  • As any veteran trader will tell you, acting on false signals means buying and selling too soon and hitting stop-loss orders before a profit target is achieved.
  • When the StochRSI is above 0.50, the security may be seen as trending higher and vice versa when it’s below 0.50.
  • The red line signal line is a 3-period moving average of %K, referred to as the slow stochastic %D line.

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