Stochastic Oscillator: How it works, Formula and Setup

The stochastic oscillator is an indicator with values from 0 to 100 which allows to compare the current price of a financial product with its maximum and minimum in a period of 14 times (14 hours, 14 days etc…). Let’s see in detail how it works. 

What is Stochastic Oscillator 

The stochastic oscillator consists of two different values, K and D, both are expressed from 0 to 100. The stochastic value K, also called fast stochastic value, represents the current price of a financial product compared to its maximum and minimum in a period of 14 times. Stochastic value D on the other hand, called slow stochastic value, is the simple moving average (SMA) of K in a 3-day period. 

How it works

The stochastic oscillator allows to compare, thanks to its value, the closing price of an asset with its trend in a previously determined period of time. In particular the stochastic oscillator allows to understand if a security is oversold or overbought. In fact, if the value of the oscillator is higher than 80 the product will be overbought, but if the value is lower than 20 the asset will be in an oversold phase. 

How to Trade with the Stochastic Oscillator 

The stochastic oscillator is an important tool in the hands of the trader, since it allows to study the trend of an asset and a possible change of trend. In particular, eventual phases of overbought can be sometimes anticipatory of descendant values of the asset, while phases of oversold can anticipate phases of upturn of the asset value.

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In any case the use of the scholastic oscillator does not allow to foresee the future and therefore it must be used together with other indicators. 

Trading signals 

As previously said, oversold and overbought phases can be respectively signals of purchase and signals of sale, however the indicator can also generate false signals for the trader.  

Very important is to analyze eventual divergent values between the trend of the asset and the tendency shown by the stochastic oscillator. Analyzing the trend of the asset in fact it is possible to be faced with two different types of divergences.

  • A bearish divergence, when the price of the financial product reaches a new maximum but the oscillator does not reach values higher than 80. In this case the missed peak reached by the oscillator could signal a possible trend reversal, i.e. a momentum of the asset value that is only temporary. 
  • A bullish divergence, i.e. an opposite situation to that just described. The value of the asset decreases but the decrease is not accompanied by an oversold phase (a value of the oscillator less than 20) and therefore also in this case the trend of the asset could only be momentary and the trend from negative could soon reverse. 

Formula and Setting 

As mentioned previously, the stochastic oscillator is composed of two different values: K and D. Both indicate two different values and are calculated through two different formulas. 

K, the fast stochastic value, is the result of the ratio of the last closing price minus the lowest price divided by the highest price minus the lowest price, all multiplied by one hundred. The formula is (Last closing price – lowest price) / (highest price – lowest price) x 100. 

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D, i.e. the slow stochastic value, is simply the moving average of K calculated over the last 3 days. 

Risk Management

The stochastic oscillator can be very useful to decide if and when to buy or sell an asset. However for a correct use and to be able to reduce the risks deriving from the unpredictability of the stock market it is necessary to know how to use the stochastic oscillator with other indicators and how to read carefully the values of the fast stochastic oscillator and the slow stochastic oscillator.

The crossovers in fact, that is the moments in which the line of the slow stochastic oscillator crosses the values of the fast stochastic oscillator, allow to foresee possible bullish or bearish tendencies. Generally in fact, when the slow stochastic oscillator is higher than the fast stochastic oscillator there could be a downturn of the asset you are analyzing, vice versa following a crossover that involves a value of the fast stochastic oscillator higher than the slow stochastic oscillator there can be an upturn of the asset. 

Useful information

When setting the parameters against which you want the stochastic oscillator to be calculated, you must consider the volatility of the asset and the timeframe within which you intend to operate. In case of particularly volatile assets it is generally recommended to calculate the fast stochastic oscillator on a period longer than 14 days and the slow stochastic oscillator on a period of at least 5 days. In the same way if the timeframe of the trading will be of short duration, it could be convenient to set the values of the stochastic oscillator higher than the classical 14 and 3, in order to avoid possible false signals. 

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Advantages and Limitations

Undoubtedly the stochastic oscillator is a valid and useful tool in the hands of the trader. However, as every tool, it cannot predict the future by itself and therefore it must be used together with other tools and properly weighted evaluations. 

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