Back to website
Understanding the Momentum Oscillator: An Indicator of Trend Strength The Stochastic Momentum Index (SMI): A Refined Indicator for Traders
3 mins read

The Stochastic Oscillator: A Guide to Understanding and Using this Momentum Indicator

What is the Stochastic Oscillator?

The Stochastic Oscillator is a momentum indicator that shows the location of the close relative to the high-low range over a set number of periods. Developed by George C. Lane in the 1950s, the Stochastic Oscillator is one of the most widely used technical indicators in the trading world.

The Stochastic Oscillator measures the current price level of an asset relative to its price range over a specific period, usually 14 periods. The indicator consists of two lines: %K and %D. The %K line is the main line and represents the current price level of the asset, while the %D line is a moving average of the %K line.

Example scanners based on the Stochastic Oscillator

The Stochastic Oscillator can be used in Scanning the market. To see how exactly it can be used in this way, we provide the following samples. Both scanners search the market for stocks using this indicator.

"TS: Stochastic Oversold" scanner by Kevin Shah
charts.trendspider.com
“TS: Stochastic Oversold” scanner by Kevin Shah
"TS: Stochastic Overbought" scanner by Kevin Shah
charts.trendspider.com
“TS: Stochastic Overbought” scanner by Kevin Shah

How does the Stochastic Oscillator work?

The Stochastic Oscillator works by comparing the current closing price of an asset to its price range over a set number of periods. The price range is the difference between the high and low prices over a specific period, usually 14.

The Stochastic Oscillator is based on the premise that in an uptrend, the closing price tends to close near the high, while in a downtrend, the closing price tends to close near the low. The indicator uses this principle to determine the momentum of an asset and identify potential buy and sell signals.

When the %K line crosses above the %D line, and both lines are below 20, it is considered a buy signal. Conversely, when the %K line crosses below the %D line and both lines are above 80, it is viewed as a sell signal.

How to use the Stochastic Oscillator in your trading strategies?

The Stochastic Oscillator is a versatile tool used in several trading strategies. Here are some ways you can use the Stochastic Oscillator in your trading:

Identifying Overbought and Oversold Levels

One of the most popular uses of the Stochastic Oscillator is to identify overbought and oversold levels. When the Stochastic Oscillator is above 80, the asset is considered overbought and oversold when it is below 20. Traders can use these levels to identify potential buy and sell signals.

Traders can also use the Stochastic Oscillator to confirm trends. When the Stochastic Oscillator is in an uptrend, and the %K line crosses above the %D line, it is considered a bullish signal. Conversely, when the Stochastic Oscillator is in a downtrend, and the %K line crosses below the %D line, it is considered a bearish signal.

Divergence Trading

Divergence trading is a popular strategy using the Stochastic Oscillator to identify potential trend reversals. When the Stochastic Oscillator is in an uptrend, and the asset’s price is in a downtrend, it is considered a bearish divergence. Conversely, when the Stochastic Oscillator is in a downtrend, and the asset’s price is in an uptrend, it is regarded as a bullish divergence. Traders can use these divergences to identify potential trend reversals and take advantage of them.

Using Multiple Timeframes

Traders can also use the Stochastic Oscillator with multiple timeframes to identify potential trading opportunities. By analyzing the Stochastic Oscillator on different timeframes, traders can better understand an asset’s overall momentum and make better-informed trading decisions.

Example strategy based on the Stochastic Oscillator

The Stochastic Oscillator can be used in Testing Strategies. To see how exactly it can be used in this way, we provide the following sample. The strategy tests buying and selling rules built around this indicator.

"TS: Stochastic Long" strategy by Kevin Shah
charts.trendspider.com
“TS: Stochastic Long” strategy by Kevin Shah

The Bottom Line

The Stochastic Oscillator is an easy-to-interpret and popular indicator used in technical analysis. It provides clues to changes in market trend momentum through its calculation of the price range of a security over a predetermined period. This momentum indicator can be adapted for traders’ varying strategies, and traders should use its signals to complement other indicators or fundamental research when making trading decisions. While the Stochastic Oscillator has limitations, it remains popular because of its simplicity and ability to identify entry points early in any financial marketplace. With careful use, competent knowledge, and given the recommended conservative approach, this tool has proven to help savvy traders comprehend market trends as well as identify potential moneymaking opportunities.

Related:

  • Moving Averages

    Introduction to Moving Averages 

    Moving averages are one of the financial industry’s most widely used technical analysis tools. Essentially, a moving average is a calculation used to analyze the average price of an asset over a given period. This calculation is based on a certain number of past prices that are averaged to provide an indication of the direction …
    Introduction to Moving Averages
  • Technical Indicators

    Demystifying Technical Indicators: Understanding the Role of Technical Indicators in Trading 

    Introduction to Technical Indicators Purpose of Technical Indicators in Trading Technical indicators are essential tools for traders to help them better understand price movements, trends, and potential trading opportunities. They are mathematical calculations based on historical price data, volume, and/or other factors that are used to forecast future price movements. The Development of Technical Indicators …
    Demystifying Technical Indicators: Understanding the Role of Technical Indicators in Trading
Understanding the Momentum Oscillator: An Indicator of Trend Strength The Stochastic Momentum Index (SMI): A Refined Indicator for Traders