In technical analysis of trading financial instruments, the Stochastic Oscillator is a momentum indicator that attempts to predict price turning points by comparing the closing price of a financial instrument to its high- low price range. In the case of an uptrend, prices tend to make higher highs, and the closing price usually tends to be in the upper end of that time period’s trading range. When the momentum starts to slow, the closing price will start to retreat from the upper boundaries of the range, causing the stochastic indicator to turn down.
The Stochastic Oscillator compares the closing price with the price range for the same financial instrument over a certain period of time. The Stochastic is plotted in the form of two curves, which are the percentage of K – the price range, and the Moving Average of the percentage K, line D. Usually, the K line is displayed as a solid line and D as a dotted line.
There are several ways to interpret the Stochastic Oscillator. The most common are:
– Buy when the Stochastic drops below certain value (for example 20) and then rise above this level. Apparently, we can also sell when the Stochastic rises above a certain level (for example 80) and then drops below it.
– Buy when the K line rises above the line D, and sell when the K line falls below the D line.
– Find deviations, for example: when the price continues to develop a series of higher highs and the Stochastic fails to exceed previous levels.
An event known as “stochastic pop” occurs when the price breaks out a certain level and the stochastic keeps going. This is interpreted as a signal to increase the current position, or liquidate if the direction is against the current position.
The Stochastic Oscillator makes it easy to identify overbought and oversold levels as well. The oscillator ranges from zero to one hundred. No matter how fast a price advances or declines, the Stochastic Oscillator will always fluctuate within this range. Traditional settings use 80 as the overbought threshold and 20 as the oversold threshold. These levels can be adjusted to suit personal analytical needs and financial instrument characteristics. Readings above 80 for the 20-day Stochastic Oscillator would indicate that the underlying price was trading near the top of its 20-day high-low range. Readings below 20 indicates that the currency pair is trading at the lower end of its range.