Stochastic Oscillator: What It Is, How It Works, How To Calculate

stochastic oscillator definition

Overbought and oversold levels mean that the security’s price is near the top or bottom, respectively, of its trading range for the specified time period. The stochastic oscillator is built on the assumption that closing prices should confirm the current trend’s direction. However, the RSI tracks overbought and oversold levels by measuring the momentum of price movements. In other words, the RSI was designed to measure the speed of price movements, while the stochastic oscillator formula works best in consistent trading ranges. Nevertheless, it’s not recommended to trade using only the stochastic oscillator as a momentum indicator. In the simplest stochastic oscillator strategy, signals are filtered by the trend direction.

The signals of a bullish reversal work well when the market is temporarily oversold in the uptrend. Signs of a bullish correction will likely work if the market entered an overbought area in the downtrend. Looking at this instrument’s historical price movements, it’s visible that the price decline doesn’t always follow a stochastic move to the overbought area.

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If it is in the oversold area, you should open a long trade to avoid losing money rapidly. The stochastic oscillator formula is considered effective when it is used on a 1-minute timeframe as well as on hourly, daily, or weekly timeframes. In this article, you will find the most comprehensive overview of the stochastic oscillator. We will cover its structure, signals, and compatibility with other instruments.

(The default setting for the Stochastic Oscillator is 14 time periods – hourly, daily, etc.) A reading of 0 represents the lowest point of the trading range. A reading of 100 indicates the highest point during the designated time period. Traditionally, readings above 80 indicate that the instrument is in the overbought range, and readings under 20 suggest oversold conditions. Oversold and overbought levels can be used to forecast trend reversals. The settings on the Stochastic Oscillator depend on personal preferences, trading style and timeframe. A shorter look-back period will produce a choppy oscillator with many overbought and oversold readings.

History of the Stochastic Oscillator

We’re also a community of traders that support each other on our daily trading journey. In general, the area above 80 indicates an overbought region, while the area below 20 is considered an oversold region. Stochastics are most effective in broad trading ranges or slow-moving trends. An important point in relation to the divergence strategy is that trades should not be made until divergence is confirmed by an actual turnaround in the price.

Bullish divergences show that the negative momentum has decreased. A bearish divergence occurs if the price makes a higher high than recorded on the oscillator. As with moving averages, when the two stochastic lines (%K and %D) cross, a signal is generated. If the white %K line crosses below the red %D line, a possible sell signal is generated.

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The stochastic is an oscillator of the technical analysis that reflects the price impulse regarding a chosen period. This allows traders to determine correction and reversal features within a trading range using the most recent closing price that helps define entry points. The stochastic oscillator is a high-frequency indicator that can generate false signals, especially in strong directional movements. It makes sense to use the oscillator with other trend indicators. Let’s consider the most popular combinations using any type of stochastic oscillator with other tools, such as the stochastic RSI. A bearish pattern occurs when the new lowest price has higher lows, but the oscillator forms a lower minimum, indicating strong sell signals.

  • There, new traders can open a free demo account to get started with no risk at all, or sign up for a free trading account and get started profiting right away.
  • For example, when the oscillator indicates bearish divergence, the price may still continue climbing higher for several trading sessions before turning to the downside.
  • However, even certain indicators, such as the stoch oscillator, can be even more helpful if trendlines are drawn.
  • An instrument won’t necessarily fall in price just because it is overbought.

Similarly, at times, the two lines will remain in the oversold level while the price is falling. This is a classic divergence where prices are headed higher, but the underlying indicator (the Stochastic Oscillator) is moving lower. When a divergence occurs between an indicator and prices, the indicator typically provides the clue as to where prices will head. Let’s take a look at the strategy of Bollinger bands and stochastic oscillators through an example. In another version of the stochastic strategy on Forex, you should wait for the stochastic to enter overbought or oversold areas to fix profit. First, we add three exponential moving averages with periods of 50-, 100-, and 200-bars.

Stochastic Oscillator Oversold Upturn

As a result, the indicator can be used to predict trend reversals. A divergence occurs when the stochastic oscillator and trending price move away from each other – indicating that a price trend is waning and may soon reverse. A bullish divergence occurs when an asset’s price makes a new low, but the oscillator does not correspondingly move to a further low reading. A bearish divergence occurs when an asset’s price moves to a new high, but the oscillator does not correspondingly move to a new high reading. As a bound oscillator, the Stochastic Oscillator makes it easy to identify overbought and oversold levels. No matter how fast a security advances or declines, the Stochastic Oscillator will always fluctuate within this range.

stochastic oscillator definition

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