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Stochastic oscillator

The stochastic oscillator is an indicator that helps determine when the price of an asset is about to change direction. It does this by giving signals on whether an asset is overbought or oversold.

If the asset is overbought, it could be due for a reversal to the downside and if oversold, it could be due for a reversal to the upside.

Traders use the stochastic oscillator to help them exit existing trades before a trend changes. They also use it to enter trades just as a new trend is beginning.

The stochastic oscillator helps determine when the price of an asset is about to change direction. Traders use it to find entry and exit points in the market.

The stochastic oscillator comprises two moving average lines

The stochastic oscillator is made up of two moving average lines that travel in and out of three distinct zones on a chart — an overbought zone at the top, a neutral zone in the centre and an oversold zone at the bottom.

Under the standard settings, the overbought zone occurs between the 80 and 100 levels on the indicator chart while the oversold zone occurs between the 0 and 20 levels.

The image below shows how the stochastic oscillator appears in a chart when applied to price action:

  1. The lines are in the overbought zone – the price could be due to reverse down
  2. The lines are in the oversold zone – the price could be due to reverse up
  3. Neutral zone

The stochastic oscillator shows extreme levels

Oversold means that seemingly excessive selling pressure has pushed an asset's price irrationally low. The appearance of an asset's moving average lines in the oversold zone would therefore suggest to a trader that an asset's direction was about to change from downwards to upwards, and they would look to buy at this point.

  1. The moving average lines have crossed below the 20 line
  2. Potential buy opportunity when the moving average lines cross back above the 20 line

 

If the moving average lines are in the 80 zone, the asset could be due for a reversal to the downside. If the moving average lines are in the 20 zone, it could be due for a reversal to the upside.

 

Overbought means the opposite. An asset's moving average line crossing in this 80 zone would therefore signal a shift to a downward trend for the asset and a selling opportunity for a trader.

In the following image, the stochastic lines have crossed above the 80 line, indicating an overbought, or bearish signal. Then when the line crosses the 80 line to the downside, a trader would look to place a potential sell order.

  1. The moving average lines have crossed above the 80 line
  2. Potential sell opportunity when the lines cross the 80 to the downside

The crossing of the lines also provides a signal

One of the moving average lines used in the stochastic oscillator - the signal line - reacts to price changes more quickly than the other. This faster line tends to give earlier warnings of an asset becoming overbought or oversold.

In the following image, the signal line has crossed above the slower moving average below the 20 line, indicating an oversold, or bullish, signal.

  1. The signal line
  2. The slower line
  3. The signal line crosses the slower line, indicating a bullish signal
One of the moving average lines in the stochastic oscillator changes more quickly, giving earlier warnings as to whether the asset will become overbought or oversold.

The moving average lines can dip into the zones

Another way of using the stochastic oscillator is to check when either of the moving average lines dip below 20 and then rise back above 20. This is considered a bullish signal, with prices expected to rise. If either line rises above 80 and then dips below 80, this is considered a bearish signal, with prices expected to fall.

In the following image, the signal line dips below 20, and then rises back above it. This would present an opportunity to buy.

  1. The signal line crossed the 20 and dips below
  2. Potential entry signal when the line crosses back above the 20

When changing the parameters of the stochastic oscillator, it is important that you test whether the changes are actually improving or worsening your trading results.

 

Summary

In this lesson, you have learned ...

  • … the stochastic oscillator is an indicator that helps predict reversals in the price of an asset.
  • … it measures an asset's recent closing price relative to its high-low range over a period of time.
  • … traders use it to help them exit trades before a trend changes direction or enter before a new trend begins.
  • … it is made up of two moving average lines that travel in between three zones on a chart: overbought (80-100), neutral (20-80) and oversold (0-20).
  • … one of the moving average lines – the so-called 'signal' line – reacts more quickly than the other line so gives earlier overbought/oversold warnings.
  • … the appearance of the moving average lines in the oversold zone suggests that an asset's price will change direction to upwards, offering a buying opportunity.
  • … the appearance of the moving average lines in the overbought zone suggest that an assets's price will change direction to downwards, offering a selling opportunity.
  • … if either moving average line dips below 20, then rises above 20, prices are likely to rise; if either line rises above 80, then dips below 80, prices are likely to fall.
  • … expanding the indicator's overbought/oversold zones will provide signals faster but also increases the number of false signals.
  • … the indicator's standard setting for zone size are considered to be the most effective and traders rarely change them.
  • … raising the indicator's standard setting of 5, 3, 3 will also cause the moving average lines to enter the overbought/oversold zones more quickly.
  • … decreasing the indicator's standard setting of 5, 3, 3 will have the opposite effect.
  • … when changing any of the indicator’s settings, it is vital to test whether the changes are improving or worsening your trading results.