By Taro Hideyoshi – The Stochastic Oscillator is an overbought/oversold indicator developed by Dr. George Lane. The stochastic is a common indicator that is integrated into every charting software including MetaStock.
Put simply, the Stochastic Indicator (SI) is a price oscillator which compares today’s price to its price range over a specific period of time. For example a 14-day SI, compares a derivative of today’s price with price 14 trading days ago. We will not go deep to the actual calculation here. Believe me! you will be glad that we do not.
In an uptrend, the price usually moves to the upper end of the recent price range. In a downtrend, the price sinks to the bottom of the range.
Stochastic Indicator is displayed in two lines; the major line is called %K (usually displayed in solid) and the %D (usually displayed in dotted line) as a 3-day moving average of %K.
There are two forms of stochastic, fast stochastic and slow stochastic. The one mentioned earlier is fast stochastic. The slow stochastic is a smoothed version of fast stochastic. It usually moves more gradually.
According to the strong correlation between tops and bottoms in price and SI tops and bottoms, the SI, therefore, is a powerful indicator and used-widely in short-term trading or day trading.
How to apply Stochastic Indicator in Trading?
Whether fast or slow and whether period you use, the important buy/sell signals from stochastic are as follows.
1. The SI around 75% to 80% indicates that a top is imminent (overbought).
2. The SI around 25% to 20% is often an imminent sigh of a bottom (oversold).
3. Buy when SI is in oversold zone and the faster %K line crossed above the slower %D line.
4. Sell when SI is in overbought zone and the %K crosses the %D to the downside.
5. Look for divergences, it tells you that the price is going to reverse. If price makes a new high and at the same time that the stochastic makes lower high. This is called a “bearish divergence”. The “bullish divergence” is when the price makes a new low while the stochastic makes higher low.
Many traders use stochastic indicator as stand-alone system. Although there is nothing wrong with this approach. I would suggest you to use it with others indicators or chart patterns to confirm the signal.
Every indicator and method has its pros and cons. Use it to support each others. Do not take unnecessary risks; watch out for signals from your trading system. If all indicators are in gear, it is the stronger and safer signal for you to enter a trade.
About the Author
Taro is an experience trader who trades in stocks, futures, forex. He strongly focuses on technical analysis, trading systems and money management.
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