Explaining the Stochastic Oscillator

In the denominator, you would take the difference between the highest high and lowest low prices over that same period. In the chart of eBay above, a number of clear buying opportunities presented themselves over the spring and summer months of 2001. There are also a number of sell indicators that would have drawn the attention of short-term traders.

Crossovers in the overbought or oversold region occur when both lines in the stochastic indicator cross in either the overbought or oversold zone. Whenever you’re acting on a signal from the stochastic indicator, always confirm with another technical analysis indicator. Similarly, a bearish or negative divergence occurs when the indicator moves lower as the security moves higher instead of moving in alignment with the price action. The stochastic momentum index (SMI) is based on the stochastic oscillator, and both tools are used to determine momentum in the market.

What are Bull/Bear Set-Ups in the context of the Stochastic Oscillator?

The stochastic oscillator is a valuable indicator for overbought and oversold conditions. Typically, readings above 80 indicate that the instrument is in the overbought range, and readings under 20 suggest oversold conditions. Furthermore, oversold and overbought levels can be used to forecast trend reversals. Both are https://www.bigshotrading.info/blog/fibonacci-retracement/ stochastic tools that are used to determine momentum in any given market condition. The stochastic oscillator is a more basic technical analysis tool and shows directional momentum based on the asset’s closing price. The primary limitation of the stochastic oscillator is that it has been known to produce false signals.

A reading of 100 indicates the highest point during the designated time period. To read stochastic oscillators, you first need to know that the stochastic indicator is range-bound, always scaled between 0 and 100, making it a valuable indicator of overbought and oversold conditions. The settings on the Stochastic Oscillator depend on personal preferences, trading style and timeframe. A shorter look-back period will produce a choppy oscillator with many overbought and oversold readings. A longer look-back period will provide a smoother oscillator with fewer overbought and oversold readings. Chart 5 shows Autozone (AZO) with a support break in May 2009 that started a downtrend.

What Is the Stochastic Oscillator?

80 and 20 are the most commonly used levels, but these can also be modified according to different needs. Yarilet Perez is an experienced multimedia journalist stochastic oscillator definition and fact-checker with a Master of Science in Journalism. She has worked in multiple cities covering breaking news, politics, education, and more.

However, traders need to avoid blindly shorting at overbought levels in upward trending markets; and going long in down trending markets purely based on oversold conditions shown by the indicator. The Stochastic Oscillator is a momentum indicator that shows the speed and momentum of price movement. According to an interview with Lane, the Stochastic Oscillator “doesn’t follow price, it doesn’t follow volume or anything like that.

Using the Stochastic With Other Tools

It’s an easy fix, as you will see in this quick primer on Stochastics settings and interpretation. It calculates the distance of the current closing price as it relates to the median of the high/low range of price. William Blau developed the SMI, which attempts to provide a more reliable indicator, less subject to false swings.

Understand that whatever you choose, the more experience you have with the indicator will improve your recognition of reliable signals. Short-term market players tend to choose low settings for all variables because it gives them earlier signals in the highly competitive intraday market environment. Long-term market timers tend to choose high settings for all variables because the highly smoothed output only reacts to major changes in price action.

The solid black line in the image below is called the %K and is determined by a specific formula (explained later in the article), while the red dotted line is a 3-period moving average of the %K line. To avoid such frustration, new traders ought to have a solid understanding of the underlying mechanics of the stochastic oscillator viewed in relation to present market conditions. Similarly, a bullish divergence occurs when the market price makes a new low but the oscillator does not follow suit by moving to a new low reading. Bullish divergence indicates a possible upcoming market reversal to the upside.

Closing levels that are consistently near the top of the range indicate sustained buying pressure. Securities can also become oversold and remain oversold during a strong downtrend. Closing levels consistently near the bottom of the range indicate sustained selling pressure.