What Is a Stochastic Oscillator?

What Is a Stochastic Oscillator?

Let me explain what a stochastic oscillator is—it's a momentum indicator that compares a security's closing price to its price range over a specific period. You can adjust its sensitivity by changing that time frame or using a moving average on the results. I use it to spot overbought and oversold trading signals, and it operates within a 0-100 bounded range.

Key Takeaways

You should know that the stochastic oscillator is a widely used technical indicator for identifying overbought and oversold conditions. It's a momentum tool first created in the 1950s. These oscillators fluctuate around a mean price level because they're based on the asset's price history. They measure the momentum of an asset's price to spot trends and forecast reversals. Readings above 80 suggest the asset is overbought, while below 20 indicate it's oversold.

Understanding the Stochastic Oscillator

The stochastic oscillator is always between 0 and 100, making it great for spotting overbought and oversold states. Traditionally, over 80 means overbought, and under 20 means oversold, but remember, these don't always signal an immediate reversal—strong trends can keep those conditions going for a while. Instead, watch for changes in the oscillator to hint at upcoming trend shifts.

In charting, you'll see two lines: one for the oscillator's value each session and another for its three-day simple moving average. When these lines cross, it signals a potential reversal because it shows a big momentum shift day to day. Also, look for divergences—if a bearish trend hits a new low but the oscillator shows a higher low, it might mean the bears are losing steam and a bullish reversal is coming.

Keep in mind, this is just one tool among many that option traders use to time their entries and exits.

Formula for the Stochastic Oscillator

Here's the formula you need: %K = ((C - L14) / (H14 - L14)) × 100, where C is the most recent closing price, L14 is the lowest price in the last 14 trading sessions, H14 is the highest in that period, and %K is the current stochastic value.

%K is sometimes called the fast stochastic. The slow version uses %D as the 3-period moving average of %K. The idea behind it is that in an uptrending market, prices close near highs, and in downtrends, near lows. Signals come when %K crosses %D.

The slow stochastic differs by adding a 3-period smoothing to %K; set it to 1 and you get the fast version.

History of the Stochastic Oscillator

George Lane developed the stochastic oscillator in the late 1950s. As he designed it, it shows where a stock's closing price sits relative to its high and low over a period, usually 14 days.

Lane has said in interviews that it doesn't follow price or volume directly—it tracks the speed or momentum of price. He notes that momentum changes before price direction does, so the oscillator can predict reversals via bullish or bearish divergences. That's the key signal he identified.

Example of the Stochastic Oscillator

You'll find the stochastic oscillator in most charting software, typically set to 14 days, but you can tweak it. Calculate it by subtracting the period low from the current close, dividing by the period range, and multiplying by 100.

For instance, if the 14-day high is $150, low is $125, and close is $145, it's (145-125) / (150-125) * 100 = 80. This shows how consistently the price closes near its recent high or low—an 80 reading means it's nearing overbought.

Relative Strength Index (RSI) vs. Stochastic Oscillator

Both RSI and stochastic are momentum oscillators used in technical analysis, often together, but they differ in theory. Stochastic assumes closing prices follow the trend direction. RSI measures price movement speed to track overbought/oversold.

RSI suits trending markets better, while stochastic works well in sideways or range-bound ones.

Limitations of the Stochastic Oscillator

The main issue is false signals—where the indicator suggests a trade, but the price doesn't follow, leading to losses. This happens often in volatile markets. To counter it, filter signals by the overall trend, only taking those that align with it.

How Do You Read the Stochastic Oscillator?

It shows recent prices on a 0-100 scale, with 0 at the period's low end and 100 at the high. Above 80 means it's near the top of the range, below 20 near the bottom.

What Does %K Represent on the Stochastic Oscillator?

%K is the current price as a percentage of the high-low range over the period—it's where the price sits in that recent range.

What Does %D Represent on the Stochastic Oscillator?

%D is the 3-period average of %K, showing the longer-term trend and confirming if the price direction is sustained.