The stochastic oscillator can help traders with a trend based trading strategy to anticipate changes in price direction and generate trading signals. Especially over the last decades the stochastic oscillator has become an important tool to many traders. If you follow a trend based strategy too, you should take some time to familiarize yourself with the stochastic oscillator.
The stochastic oscillator, sometimes also shortened as K%D, is a momentum indicator. By comparing the current closing price of an asset to its trading range, the stochastic oscillator attempts to predict turning points in price movements.
The logic behind this idea is simple: Every trend rises or falls with a certain speed. The trading range rises or falls with the trend. In an uptrend, closing prices are usually closer to the upper end of the trading range. In a downtrend, closing prices are usually closer to the bottom end of the trading range. Sometimes, however, prices move outside this trading range. Most of the time the market is not able to sustain the accelerated movement, and prices will eventually move back into the trading range. The stochastic oscillator can help you find such events and profit from the impending turnaround.
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The stochastic oscillator consists of two lines, the %K line and the %D line. The %K line measures how the current closing price is in relation to the total price range for the defined time period. The result will be converted into a percent value and is plotted into the diagram. A value of 0 means that the current closing price is at the absolute low end of the trading range, a value of 100 means it is at the absolute top end. A value over 80 is considered significantly high, and a value below 20 is considered significantly low.
The second line of the stochastic oscillator, the %D line, can be calculated in two ways: Some traders use a three period moving average of the %K line to create the %D line, which is called fast stochastics. Other traders create another 3 period moving average of the %D line to generate a smoother line, which creates more reliable signals and is called slow stochastic. Which version you choose for your trading should depend on your risk tolerance. Risk-averse traders will be better off with the slow stochastic while more risk-tolerant traders should use the fast stochastics.
The %D formula creates a second line, which is also plotted into the diagram. Since the %D line is a moving average of the %K line, it is slower to react and will follow the %K line.
While the stochastic oscillator was originally designed to be used with daily and weekly charts, it can deliver just as good results when used with intraday charts. Most commonly, the stochastic oscillator is used over a time period of 14 periods.
The most important trading signal created by the stochastic oscillator is a divergence between the %D line and the price movement while the %D line is in an overbought or oversold area. This event occurs when prices reach a new top or bottom, but the %D line fails to do so as well. You can see such an event in the picture above. While prices have reached a double top, the stochastic oscillator has a significantly lower value during the development of the second top. This is considered a bearish divergence and can be used to invest in falling prices.
Some traders, however, like to wait until the %K line crosses the %D line before they invest. This adjustment is supposed to generate more refined signals. As you can see in the picture, both techniques are valid. Which one you should use highly depends on how you want to trade the signal. Trading the divergence requires options with a longer expiration time in relation to the time frame of your price chart, while the crossing of the %D line by the %K line should be traded with a shorter expiration time.