The stochastic oscillator is a momentum indicator that measures how powerful a price move is. Although the formula can be applied to any kind of data, it is most often used with closing prices of stocks, ETFs or other tradable securities. The indicator shows where the closing price is in relation to the recent trading activity.
The stochastics formula is: (Current Close - Lowest Low) / (Highest High - Lowest Low) * 100
When the close is near the recent lowest low, the stochastic oscillator will be near 0 and the price may be considered oversold. An overbought condition exists when the current close is near the highest high and the stochastic value is near 100.
How Traders Use It
Trading solely with the stochastic oscillator is challenging. Trade signals are generated when the indicator moves above or below key levels.
In the example shown below, using the blue line in the middle of the chart, buy signals are given when the indicator moves above 20 and sell signals occur when it falls below 80. One problem with this approach is that there can be repeated buy signals before a sell signal occurs, or vice versa. It is also possible that a new trend could develop without a signal being given.
To address these problems, some traders add a moving average to the stochastic indicator. The indicator itself can be slowed with a moving average, creating what is called a slow stochastic. The raw indicator values are called the fast stochastic. Then a moving average is placed on top of the slow stochastic. A common moving average is three days for both calculations.
This technique, applied as a three-day moving average on the slow stochastic, is shown in the bottom portion of the chart above. Signals are more frequent and can now occur at any time, rather than only at oversold or overbought extremes.
Why It Matters To Traders
Stochastics are most often applied with the moving averages added to the indicator, and when the two lines cross, the stochastic oscillator can sometimes provide a very timely signal on very short-term charts. That makes this tool a favorite of day traders.
However, on a stand-alone basis, traders should expect a number of false signals and losing trades from the stochastic oscillator. Ideally, this indicator is combined with several other tools to create more complex trading systems.
Oscillators work best when prices are in a trading range, and a measure of the strength of a price trend, such as the Average Directional Index (ADX), could be especially helpful in filtering signals generated with the stochastic oscillator.
Long-term traders can apply stochastics to weekly or monthly prices. A healthy bull market will show a reading above 80 for an extended period of time while a bear market will generally be accompanied by a value below 20 for weeks or months at a time.
When these long-term indicators change direction, that is often a sign that the price trend is undergoing a significant reversal and traders could become more aggressive with their positions. They could increase exposure to stocks, for example, if the monthly stochastics for the S&P 500 index rises above 20 and decrease exposure when that indicator falls below 80.
(This article originally appeared on ProfitableTrading.com.)