Technical Analysis Tools And Indicators
Stochastic Oscillator Basics Explained
Stochastics Oscillator is an indicator developed by George Lane and is a must have tool for any trader. It measures the relationship between the closing price & its price range over a predetermined period of time.
Usually, the mathematical number 14 is taken in any given time frame, viz. hourly, daily, weekly or monthly to determine the price range of that period.
Formula for Stochastic indicator calculation
Stochastics is measured with the %K line and the %D line, and it is the %D line that we follow closely, as it will indicate any major signals in the chart. Mathematically, the %K line is derived from the following formula :
%K = 100[(C – L5close)/(H5 – L5)]
C = the most recent closing price
L5 = the low of the five previous trading sessions
H5 = the highest price traded during the same 5 day period.
The formula for the more important %D line is as follows :
%D = 100 X (H3/L3)
So now that we have the formula of how Stochastic indicator consists of, let us have a look at the chart of LUPIN below to see the example of how Stochastics indicator can be used as a lead indicator for a trend change, the continuation of trend or exhaustion of trend.
In the above chart, we can see that the K-line is the fastest and D-line is the slowest of all. Like RSI or MACD, we can look for divergences between the Stochastics & Price. For example, if the price is making lower lows and Stochastic is making higher lows then it’s a sign of exhaustion of downtrend and we look to buy into that scrip once we get a confirmation from price & vice versa for price making higher highs and Stochastics making lower highs.
The other way to follow it as a lead indicator for a trend is that we look for a crossover of K & D line for buy or sell.
Though in general trading if Stochastics is quoting at 20, then it’s meant to be in the oversold zone & if it’s trading above 80 it’s considered to be overbought zone. So we look for a positive or negative crossover near those levels and try to capture the upcoming move.
But the 20 & 80 levels are not be taken as buying or selling levels without the price confirming the reversal. As you can see in the above chart, the price trends the most ( Green & Pink Arrows) in overbought & oversold levels (Marked in Pink Box).
Due to the accuracy or leading nature of the Stochastic indicator, few traders use it as one of their top priority indicators for trading.