Technical Classroom: How to trade profitably using Stochastic Oscillator

Construction of Stochastic Oscillator

The Stochastic Oscillator compares where a security's price closed relative to its price range over a given time period (default is 14). The Stochastic Oscillator is displayed as two lines. The main line is called "%K" The second line, called "%D," is a moving average of %K.

The stochastic oscillator is calculated using the following formula: First, a value known as %K is calculated as mentioned - Figure .2 Stochastic Oscillator Formula

However %D is the 3-day moving average of %K (the last 3 values of %K), and these 2 lines are plotted on charting software, having min value of 0 and max value of 100. This gives us idea about stochastic as a limiting oscillator unlike MACD.

Trading ideas with Stochastic Oscillator

Overbought / Oversold Levels

The misinterpretation of overbought and oversold is one of biggest problems and faults in trading. The Stochastic indicator more than showing oversold or overbought prices shows momentum of the price trend. Figure .3 Stochastic oscillator overbought levels

Traditionally, stochastic reading above 80 is called overbought and that below 20 is called oversold. More informed interpretation is that stochastic beyond 80 suggests the up- trend is strong and that below 20 down trend is strong. A high Stochastic means that the price is able to close near the top and it keeps pushing higher. A trend where the Stochastic stays above 80 for a long time signal that momentum is high and not that one should get ready to short the market. In these conditions once %k crosses %D line and/or starts showing divergence implies possibility of trend reversal.

Trading Technique:

•> Trending: As long as the Stochastic keeps crossed in one direction, it shows that the trend is still valid, and it becomes strong as it crosses center line marked around 50. As mentioned very useful tool in trending market.
•> Breakout: When Stochastic is suddenly accelerating into one direction and the two stochastic bands are widening, then it can signal the start of a new trend. If it is accompanied by price breaking out of a sideways range, even better. We can use trend line to find out breakout on oscillators and initiate a break out trade too. Figure 4 Trading with Stochastic oscillator

•> Breakdown: When the Stochastic is changing the direction and leaves the overbought/oversold areas, it can foreshadow a reversal. One can also combine the Stochastic with a moving average or trend lines.
•> When we look for a bullish reversal, we need to see the green stochastic line to get above the red one and leave the overbought-oversold area.
•> Divergences: As with every momentum indicator, divergences can also be a very important signal here to show potential trend reversals, or at least the end of a trend.
•> Crossover: When the %K Stochastic crosses over and moves above the %D Stochastic, the interpretation is that the market rate is gaining at a faster rate than the average represented by the %D Stochastic. This increase in price strength is considered a buy signal and vice versa for sell signal.

Conclusion

•> The term stochastic refers to the point of a current price in relation to its price range over a period of time (default 14).
•> One can use stochastic oscillator to measure the speed and momentum of a price over a time period.
•> Stochastic oscillator works best when used with other indicators, chart patterns, and volume and price movement.

Disclaimer: The author is Head - Technical & Derivative Research at Narnolia Financial Advisors. The views and investment tips expressed by investment experts on Moneycontrol are their own, and not that of the website or its management. Moneycontrol advises users to check with certified experts before taking any investment decisions.