Stochastic Oscillator Explained – Overview, How to Calculate, and Uses

Stochastics are regarded as very easy to understand and accurate indicators that investors can use to know when to buy and when to sell. Naturally, this makes it one of the most favoured market indicators. In broad terms, an investor can use this particular indicator to analyze the three main types of prices of a security within the market – lowest, highest, and closing. It is called an oscillator because one can adjust the period, thus increasing or decreasing its sensitivity and altering its readings.

Stochastic Oscillator Explained – Overview, How to Calculate, and Uses

Let’s take a closer look at this essential technical analysis element - from the basics and up to the stochastic oscillator formula and its uses!

Overview

As mentioned earlier, this indicator takes the closing, highest, and lowest prices and then compares them for a predetermined period. The results oscillate between the values 0 and 100. The final readings/values show momentum – not movement/trends. 

• The default period setting is 14 – can be used for hourly, daily, etc. measurements. 
• The readings provided are basically the trading range’s values/points in the form of percentages. 
• 0 implies the lowest point.
• 100 implies its highest point. 

Formula/How to Calculate Stochastic Oscillator

The following formulas are used: 

%K = (C – LL) / (HH – LL) x 100 
%D = 3-day SMA of %K 

In the above: 

• C represents the last closing price. 
• LL represents the period’s lowest low. 
• HH represents the period’s highest high. 
• %K represents the K line. 
• The %D line is the more important one and it is slower than the aforementioned one. The price is or will be affected when this line sees values of over 80 or under 20 on the line. 

Uses 

Now, let’s move on to the interesting part – namely, how can one use a stochastic oscillator while investing! After all, modern charting software will apply the formula above for you. 

Oversold/Overbought Readings 

Readings over 80 signal an overbought level, while readings under 20 imply and oversold level. Given this information, an investor will know when to sell (above 80) and when to buy (under 20). 

Divergence 

There may be times when prices go beyond their lowest and highest. This creates a divergence. Despite the changes in values/prices, the oscillator will not show new readings right away. 
New prices beyond the extreme values also create bullish and bearish divergences that people can use to predict future changes. 

Crossovers 

At times, the two lines may intersect. This creates various situations. 
A bullish situation is created when K meets with D and goes above it, while a bearish situation happens when K comes from above, meets D, and goes under it.

The Bottom Line about Stochastic Oscillator 

Last but not least, it is worth mentioning that the stochastic oscillator is also known for its errors and inaccurate/false signals. This is the main reason why the majority of investors recommend people to wait for market validation before they make decisions based on oscillator readings. Keep in mind that Stochastic Oscillator readings are meant to analyze the weakness or the strength of a price, and not its direction.