Stochastic Oscillator Indicator: In the stock market, traders and investors rely on various technical analysis tools to make informed decisions. In that stochastic oscillator is one of the technical indicators used to analyse the securities.

The stochastic oscillator is a leading momentum indicator which helps the market participants to identify overbought, and oversold zones, trends, price reversals and potential entry/exit signals.

Here, we shall explore the concept of a stochastic oscillator Indicator with applications, strategies and charts involved.

What is Stochastic Oscillator Indicator?

The stochastic oscillator is a popular technical indicator used to measure the momentum of a security. The oscillator compares the closing price of a security to its price range over a specific period of time.

In the 1950s, Dr. George C. Lane developed the indicator based on the fact that always a change in momentum happens before a change in price, resulting to help market participants identify the overbought/oversold zone, trends and price reversals.

How to calculate?

In this oscillator, we have Fast stochastic and Slow stochastic.

For fast stochastic %D line is a 3-period moving average of %K line. Whereas for the slow stochastic, %K line is a 3-period moving average of %D line.

The fast stochastic respond more sensibly to the price change of a security compared to the slow stochastic.

The line %K is calculated by 

%K=[(C – L14)/(H14 – L14)] X 100

Where, 

C = recent closing price

L14 = lowest price of a security traded in the last 14 periods

H14 = highest price of a security traded in the last 14 periods.

For the %D line,

%D = (SMA) X (%K)

Where,

SMA = Simple moving average 

Generally, for %D, a 3-period moving average is considered here.

Strategies with Stochastic Oscillator Indicator

The stochastic indicator is used as a technical tool strategy, which helps traders analyse the price of a security for a better view of entry/exit opportunities.

Let us understand below how to use a stochastic oscillator Indicator to build entry/exit strategies.

Overbought and Oversold levels

A stochastic oscillator is used to generate overbought and oversold levels. The oscillator ranges between 0 to 100. Usually, the default settings are set to 20 and 80 range in charts.

When the stochastic oscillator ranges between 80 to 100 it is considered as the overbought zone, and here one could look for an exit of the long position and entry to the short position of security.

For the oversold zone, when the oscillator oscillates between the range of 0 to 20, then the price of the security is considered to be oversold and here the opportunity for a long position can be spotted and the short position can be squared off as a signal to trend reversal.

Here, it should be understood that an overbought level doesn’t mean bearish and an oversold level doesn’t mean bullish always. In a strong trend, the oscillator remains in the overbought or oversold zone for a period. So it is important to understand the direction of the trend and place a position.

(Source: TradingView)

Chart of Reliance Industries with stochastic oscillator indicating overbought and oversold zones.

Divergence

Divergence is the concept of disagreement between the price of a security and the technical indicator movement. In divergence, we have two types 

1. Bullish Divergence
2. Bearish Divergence

1. Bullish Divergence

A bullish divergence occurs when the price of the security makes a lower low and in parallel to it, the stochastic oscillator makes a higher low, which indicates that the downside momentum of the price is gradually decreasing, with the upside price reversal will be registered.

(Source: TradingView)

2. Bearish Divergence

In a bearish divergence, the price of a security makes a higher high while the stochastic oscillator makes a lower high, indicating the upward price momentum is slowing down. Here, it can be understood that the security is ready for a downtrend.

(Source: TradingView)

Crossover

The stochastic oscillator crossover is another important strategy used by traders. 

When the %k line intersects the %D line a crossover can be seen. 

In the stochastic oscillator, when the %K line crosses over the %D line it is considered as a buy signal to enter a long position.

As the %K line crosses below the %D line a sell signal will be generated to exit the long position and to enter a new short position.

The crossover strategy is more accurate when the crossover buy signal occurs in the oversold region and the crossover sell signal occurs in the overbought range.

(Source: TradingView)

Chart of Bajaj Finance LTD indicating stochastic oscillator crossover strategy.

Relative Strength Index (RSI) with Stochastic Oscillator Indicator

The combination of two indicators will always generate much better signals. Here, we shall see how to use RSI with a stochastic oscillator and generate entry/exit signals.

The relative Strength Index(RSI) is a leading momentum indicator that measures the speed and change of price movements.

We have learned the cross-over strategy of stochastic indicator, when the RSI indicator oscillates above the middle line, it is considered as a confirmation for the buy signal generated with stochastic crossover.

For confirmation of a sell signal generated by the crossover strategy of a stochastic oscillator, the RSI should oscillate below the middle line.

Here, the Chart of HDFC Bank indicates RSI confirmation with a stochastic oscillator cross-over strategy for trade opportunity.

(Source: TradingView)

Limitations With Stochastic Oscillator Indicator

• Like other technical indicators, stochastic oscillator also generates false signals.
• The range of price movement is not measured with the stochastic oscillator but the momentum is measured.
• In strong trend markets, the price of the security can remain in the overbought range or oversold range for a period.

In Closing

The Stochastic Oscillator Indicator is a valuable tool used to analyze the price of securities.

It is widely used to identify overbought, oversold zones, trends, reversals and price momentum for a perfect entry/exit with risk management of the positions.

The stochastic oscillator Indicator can be set to any time frame based on the trader’s strategies for better views of the strategy. As a trader, for better opportunities in technical analysis of the securities, it is advised to use other technical tools along with a stochastic oscillator to rule out false signals.

Written by Deepak M

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