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What Is a Stochastic Oscillator?

Adam Lienhard
Adam
Lienhard

The Stochastic Oscillator is a popular momentum indicator used in technical analysis to measure the relative strength or weakness of a financial instrument’s price. It helps traders identify overbought and oversold conditions in the market, as well as potential trend reversals. Learn more about it to use it in your trading on Headway.

What is it?

The Stochastic Oscillator consists of two lines, %K and %D, plotted on a scale of 0 to 100. The formula for calculating the Stochastic Oscillator is as follows:

%K = (Current Close – Lowest Low) / (Highest High – Lowest Low) * 100

%D = Simple Moving Average of %K

The %K line is more sensitive and prone to fluctuations, while the %D line is a smoothed version of %K. 

How to read it?

The Stochastic Oscillator ranges from 0 to 100. Readings above 80 are considered overbought, suggesting that the price may be due for a downward correction. Readings below 20 are considered oversold, indicating that the price may be due for an upward correction. Traders often look for potential reversals or entry points when the indicator crosses these levels.

How to use it?

1️⃣ Identify crossovers. Traders pay attention to the crossovers between the %K and %D lines as potential buy or sell signals. When the %K line crosses above the %D line, it generates a bullish signal, suggesting that upward momentum may be strengthening. Conversely, when the %K line crosses below the %D line, it generates a bearish signal, indicating that downward momentum may be increasing.

2️⃣ Identify overbought and oversold conditions. When the Stochastic Oscillator rises above the 80 level, it suggests that the price may be overbought and due for a potential downward correction. This could be an opportunity to consider selling or taking profits. When the Stochastic Oscillator falls below the 20 level, it indicates that the price may be oversold and due for a potential upward correction. This could be an opportunity to consider buying or entering long positions.

3️⃣ Identify divergence. Traders also look for divergence between the Stochastic Oscillator and the price action. A bullish divergence occurs when the price forms lower lows, but the Stochastic Oscillator forms higher lows, indicating a potential reversal to the upside. A bearish divergence occurs when the price forms higher highs, but the Stochastic Oscillator forms lower highs, suggesting a potential reversal to the downside.

It’s important to note that the Stochastic Oscillator is just one tool among many used in technical analysis. Traders often use it in conjunction with other indicators, chart patterns, and analysis techniques to make well-informed trading decisions.

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