A stochastic oscillator is used to check the momentum by comparing a particular closing price of a security to a range of its prices over a certain period of time.
The sensitivity of the oscillator to market movements is reducible by adjusting that time period or by taking a moving average of the result.
It is used to generate overbought and oversold trading signals, utilizing a 0–100 bounded range of values.
A stochastic oscillator is a popular technical indicator for generating overbought and oversold signals.
How to Use the Stochastic Oscillator
The stochastic oscillator is included in most charting tools and can be easily employed in practice.
The standard time period used is 14 days, though this can be adjusted to meet specific analytical needs.
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.
As a hypothetical example, if the 14-day high is $150, the low is $125 and the current close is $145, then the reading for the current session would be: (145-125) / (150 – 125) * 100, or 80.
By comparing the current price to the range over time, the stochastic oscillator reflects the consistency with which the price closes near its recent high or low.
A reading of 80 would indicate that the asset is on the verge of being overbought.
Limitations of the Stochastic Oscillator
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.
