Learn to Trade with Stochastics

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Learn to Trade with Stochastics

What Does The Stochastic Oscillator Tell You?

The stochastic oscillator is range-bound, meaning it is always between 0 and 100. This makes it a useful indicator of overbought and oversold conditions.

Traditionally, readings over 80 are considered in the overbought range, and readings under 20 are considered oversold. However, these are not always indicative of impending reversal; very strong trends can maintain overbought or oversold conditions for an extended period. Instead, traders should look to changes in the stochastic oscillator for clues about future trend shifts.

Stochastic oscillator charting generally consists of two lines: one reflecting the actual value of the oscillator for each session, and one reflecting its three-day simple moving average.

Because price is thought to follow momentum, intersection of these two lines is considered to be a signal that a reversal may be in the works, as it indicates a large shift in momentum from day to day. Divergence between the stochastic oscillator and trending price action is also seen as an important reversal signal. For example, when a bearish trend reaches a new lower low, but the oscillator prints a higher low, it may be an indicator that bears are exhausting their momentum and a bullish reversal is brewing.

The stochastic oscillator

was developed in the late 1950s by George Lane. As designed by Lane, the stochastic oscillator presents the location of the closing price of a stock in relation to the high and low range of the price of a stock over a period of time, typically a 14-day period. Lane, over the course of numerous interviews, has said that the stochastic oscillator does not follow price or volume or anything similar. He indicates that the oscillator follows the speed or momentum of price. Lane also reveals in interviews that, as a rule, the momentum or speed of the price of a stock changes before the price changes itself. In this way, the stochastic oscillator can be used to foreshadow reversals when the indicator reveals bullish or bearish divergences. This signal is the first, and arguably the most important, trading signal Lane identified




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