The Stochastic Oscillator As a Trade Decision Tool

By Hugues Capet

The stochastic oscillator (%K) is a momentum indicator that indicates the price position relative to the high-low range over x periods. Mathematically speaking, it is the ratio of the day's close minus the lowest low (over x periods) to the high-low range (highest high minus the lowest low over the same x periods). The ratio is multiplied by 100 to get an oscillator ranging from 0 to 100.

The %K is equal to 0 when the day's close is equal to the lowest low. It is equal to 100 when the day's close is equal to the highest high. Assuming the high-low range doesn't change, if the price goes up, the %K goes up and if the price goes down, the %K goes down (this is obvious but important to notice since it will lead to buy/sell signals based on divergence).

The zone below 20 is called the oversold zone and the zone above 80 is referred to as the overbought zone. Those names may sound dramatic but be aware that having the oscillator in the oversold zone does not mean it's a signal to buy (the price could still fall). Similarly, the oscillator in the overbought zone is not by itself a bearish signal to sell since the price could keep going up. It is when the oscillator gets out of the zones that it gives the buy/sell signals. When the oscillator is in the oversold zone and hooks up past the 20% line, it gives a buy signal. Similarly, when the oscillator is in the overbought zone and hooks down past the 80% line, it gives a sell signal. Be aware of false signals though!

The signals are stronger if the oscillator and the stock price diverge. If the oscillator is in the oversold zone and there is positive divergence between the %K and the price (stock goes down while oscillator goes up), the crossing of the 20% line gives a (stronger) signal to buy. Similarly, if the oscillator is in the overbought zone and there is divergence between the oscillator and the stock price (negative divergence as the stock goes up while oscillator hooks down), the crossing of the 80% line is a (stronger) signal to sell. When using divergence as a trading decision tool, it usually takes two crossings for the signal to be valid (in other words, it is a good idea to disregard the first crossing).

An other way to get signals is to consider crossovers with the moving average (called %D) of the %K stochastic oscillator. As with crossovers between the stock price and its moving average, when the %K crosses the %D, it indicates the end of a trend (for the %K) and possibly a buy/sell signal.

Hugues is the webmaster of http://doublebottom.blogspot.com/ a blog dedicated to technical analysis.