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Stochastic Indicator

What is the Stochastic Indicator?

The Stochastic Indicator, or Stochastic Oscillator, is a popular momentum indicator that was developed by George Lane in the 1950s. It measures where closing price of a security is, relative to that security's the high and low (or price range) over a period of time, with the default look-period being 14. The Stochastic indicator consists of two lines – the %K and the %D – both of which fluctuate between 0 and 100. The %K line represents the change in closing price with respect to the high and low of the specified look-back period while the %D line is a soothing average of the fast %K line over another specified look-back period with a default value of 3. Here the %D line is, in effect, a signal line, while the %K line is quite similar to the Williams %R indicator.

As the Stochastic indicator is bound a fixed range from 0 to 100, it is useful in identifying overbought and oversold conditions for the security being analyzed. Generally, when the Stochastic indicator is above 80, the security is thought to be overbought and when it is below 20, the security is thought to be oversold.

As the Stochastic indicator is a oscillator, overbought and oversold conditions are significant considerations for taking up a trading position, but the Stochastic indicator can also generate potential trade signals when the %K and %D crossover each other; and when the movement of the Stochastic indicator diverges from the movement of the price chart.

How to calculate the Stochastic Indicator?

The Stochastic indicator is calculated in two steps: first the %K line is determined, and then the %D line can be determined.

The %K line is calculated by subtracting the latest closing price (CP) from the lowest closing price for the look-back period and dividing it by the difference of the high and low closing prices for the same look-back period. The formula %K line is as follows:

%K = ( Latest CP − Lowest CP ) ÷ ( Highest CP − Lowest CP )

Next, the %D line is calculated by averaging the %K values for the look-back period of the %D line. This is calculated by averaging the sum of the %K values for the period of the %D and dividing it by the period of the %D line, which is a simple moving average (SMA) of the %K line. The formula for the %D line is as follows:

%D = ( %K + %K + ... n ) ÷ n

where n is the period of the %D line. If the standard look-back period (3) of the %D line is used, then it is the sum of the last three %K values divided by 3. Alternatively, an exponential moving average (EMA) or weighted moving average (WMA) can be used to determine the %D line.

How to trade with the Stochastic Indicator?

There are a number of ways in which the Stochastic indicator can be used to enter and exit trades. This includes overbought and oversold conditions, stochastic crossovers, and divergence.

Overbought and Oversold Conditions

The Stochastic indicator is a bounded oscillator that fluctuates between 0 and 100, making it ideal for identifying overbought and oversold conditions. Generally Stochastic values above 80 are considered to be in overbought conditions while Stochastic values below 20 are considered to be oversold conditions. However, the security can remain overbought or oversold for a while, and thus, more reliable entry and exit signal are generated when the %K line crosses the slower moving %D line when in overbought or oversold territory.

Stochastic Crossovers

The Stochastic indicator consists of two lines: the %K and the %D lines; with the %D line, effectively, being a smoothed signal line. More reliable trade signals are generated when the %K and %D lines crossover each other, particularly when the security is experiencing overbought or oversold conditions.

When the %K line crosses up over the %D line, it generates a bullish signal, particularly when the crossover occurs while the security is in oversold territory. This is a potential buy signal. Conversely, when the %K line crosses down below the %D line, it generates a bearish signal, particularly when the crossover occurs in overbought territory. This is a potential sell signal.

Divergences

As the Stochastic indicator is an oscillator, divergences between it and the price action can also be applied. The term divergence refers to the difference in movement between the price action of the underlying security and an oscillating indicator. This difference is encountered when the price action makes a series of higher highs or lower lows while the oscillator is making lower highs or higher lows, respectively, or is moving sideways. When this happens, the price action is not confirmed by the oscillating indicator. When divergence occurs, a potential price reversal are more likely to follow. Here again, a Stochastic crossover can be used to time entry and exit signals once divergence has occurred..

Finally, George Lane also referred to a flattened %K or %D line as hinges, stating that a hinge may indicate that the current trend has become exhausted, and that the potential for a price reversal is great.

Chart Example

The following chart shows a 10, 3, 3 Stochastic indicator in the lower chart panel on a 30-minute chart of the Dow Jones Industrial Index. The blue line is the raw stochastics while the red dashed line is the smoothed signal line.

Advantages and Disadvantages of the Stochastic Indicator

Stochastics Frequently Asked Questions

What is the Stochastic Oscillator?

The Stochastic oscillator is a popular momentum indicator developed by George Lane. It compares the security’s closing price with the price range of the security over a look-back period.

What is the Stochastic Indicator used for?

The Stochastic indicator is used to identify overbought and oversold conditions. Commonly, Stochastic values above 80 are considered overbought, and Stochastic values below 20 are considered oversold. The Stochastic indicator is also used to identify divergence with the price chart.

What is divergence in Stochastics?

Divergence occurs when the price chart of the security and the Stochastic oscillator do not move in the same directions. For example, the price action on the chart is making higher highs while the Stochastic is moving sideways or making lower highs. This indicates an underlying weakness in the price action that may lead to a price reversal.

What does %K line on the Stochastic Oscillator mean?

The %K line is a measure of the current price of the security in relation to its position in the price range of the security over the look-back period.

What does the %D line on the Stochastic Oscillator mean?

The %D line is a smoothed version of the %K line and can be considered a signal line. This smoothing is achieved by applying a simple moving average (SMA) to the %K line, using a default look-back period of 3.

What is the difference between the %K and %D lines in the Stochastic Oscillator?

The %K line is a measure of the current price of the security in relation to its position in the price range of the security over the look-back period while the %D line is a smoothed version of the %K line. The %D line can be considered a signal line.

Can the Stochastic Indicator be used on any timeframe?

While the Stochastic indicator is suited for analyzing shorter-term timeframes such as the 5-minute, 15-minute, or 1-hourly charts, it can be applied to daily or weekly charts as well, making it quite versatile.

Summary

The Stochastic oscillator is a leading indicator that is one of the most popular indicators. It is an oscillating momentum indicator used mainly to identify overbought and oversold conditions and is ideal for mean-reversion trading. It identify overbought and oversold conditions by comparing a security's closing price with its price range over a specific look-back period. However, the Stochastic indicator can also generate potential trade signals when the %K and %D lines crossover each other; and when the movement of the Stochastic indicator diverges from the movement of the price chart.

The Stochastic indicator does, however, produce false signals, particularly in strong trend markets, where overbought and oversold conditions can persist for longer than anticipated, and in choppy, high volatility market conditions.