Stochastics Oscillator or Stochs for short is a trend oscillator tool used in technical analysis of the markets. Stochastics measures overbought and oversold conditions in the markets, similar to Relative Strength Index or RSI. It is one of the default trading indicators available on most trading platforms and charting packages.
While it isn’t clear as to who discovered the Stochastics Oscillator, two names pop up prominently with this indicator. Namely, Dr. George Lane and Ralph Dystant.
The Stochastics Oscillator looks identical to the MACD indicator and is made up of two lines where one is a faster signal line and works on the concept that while prices are in an uptrend, the price action tends to close at the high of the candle and vice versa when markets are in a downtrend.
The stoch oscillator is used to compare a market’s closing price to the price range over a specified period of time. The sensitivity can be tweaked by adjusting the time period or slowing period.
Constructing the Stochastics Oscillator
The stochastics oscillator has three settings. %K (K line, which is the fastest), %D (the D Line, which is the slowest) and the Slowing period and is based upon the moving averages, usually applied to closing price. The Oscillator moves between fixed variables of 0 to 100, representing extremes in overbought and oversold conditions. The key levels to look out for are when the Stochs cross the 20 and the 80 line.
The stochastic oscillator is represented by the %K Line and the %D line. Trades are taken whenever there is a crossover of the %K and %D lines at key levels of 20 and 80.
Types of Stochastics Oscillator
Market technicians have identified three kinds of stochastics oscillator based on the settings. They are:
- Fast Stochastics
- Slow Stochastics
- Full Stochastics
The above types of stochastics are nothing but the values used for %K, %D and Slowing period. The higher the values, the ‘slower’ the stochs become.
Ideally, the more smaller the settings, the more sensitive the Stochs become to the market, often resulting in whipsaws or fake signals where as the slow stochastics tends to be more smooth. Most commonly the fast stochastics is usually used in tandem with other indicators and is part of a trading system. Therefore, especially the fast stochastics should never be used as a stand alone indicator in order to pick up Buy/Sell signals.
Stochastics Oscillator – Important points
Because the Stochs is an oscillator, it is best used in ranging markets. When used with other indicators such as Moving averages or Bollinger Bands for example, Stochs can help determine or confirm especially during ranging market phases. During a trending market, the Stochastics oscillator often gives out false overbought and oversold indicators. Furthermore, when using stochastics, trades should be entered only when the %K cross the %D at the key levels of 20 and 80. A preemptive move, or entering a trade before the crossover at the key levels could leave you keeping your position open while the market is moving in the opposite direction.