According to the Merriam-Webster dictionary, the word stochastic is defined as:
- “involving a random variable.”
- “involving chance or probability.”
When it comes to trading, the stochastic oscillator is a technical momentum indicator that compares a security’s closing price to its price range for a given period.
To keep it simple, stochastics are calculated using this formula:
%K=100[(C-L14)/(H14-L14)]
C=the most recent closing price
L14= the low of the previous 14 periods
H14= the highest price reached during the last 14 periods
Oh, and let’s not forget:
%D=3 period moving average of %K
Got it?
Now in English:
The stochastic oscillator was invented in the 1950s by George C. Lane. The indicator does not focus on volume or price – instead, it focuses on momentum, because changes in momentum precede changes in direction. Stochastics can be used to identify potential reversals as well as overbought/oversold conditions. Here is what you need to know:
- A reading of 80 or above could potentially indicate an overbought market
- A reading of 20 or below could potentially indicate an oversold market
- High readings indicate sustained buying pressure
- Low readings indicate sustained selling pressure
- 50 is the centerline
Stochastics can potentially be used to time market entries and exits. You can also look for divergences between price and this oscillator for potential trading opportunities.
Two simple trade examples:
Stock ABC has reached an area of critical support and has a stochastic reading of 18. If you believe that this area will hold, you could look to buy the shares at current levels based on chart support and an existing oversold condition.
Stock ABC has reached an area of prior support and has a stochastic reading of 20. You feel the shares could potentially break this level of support and decide to wait for confirmation. The stock begins to stabilize, and you elect to go long the shares once the stochastic reading crosses above the 50 level.
There are different types of stochastics such as fast, slow, and full. This oscillator may be used with many different trading strategies and can be a useful tool for trading both trending and range-bound markets.
