What Is a Stochastic Oscillator?

  • 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.

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