Stochastic Oscillator

The Stochastic Oscillator compares a stock's closing price to its price range over a given period. It's excellent for identifying overbought/oversold conditions and momentum shifts. [DEFINITION] Stochastic Oscillator: A momentum indicator comparing closing price to the high-low range over a period, displayed as two lines (%K and %D) ranging from 0 to 100. [FORMULA] %K = ((Close - Lowest Low) ÷ (Highest High - Lowest Low)) × 100 %D = 3-period SMA of %K (signal line) ### Interpreting Stochastics **Overbought/Oversold Levels:** - Above 80 = Overbought - Below 20 = Oversold **Crossover Signals:** - %K crosses above %D = Bullish - %K crosses below %D = Bearish [TIP] Stochastic works best in ranging markets. In strong trends, it can stay overbought or oversold for extended periods. ### Trading Strategies **Classic Overbought/Oversold:** 1. Wait for stochastic to enter overbought (>80) or oversold (<20) 2. Wait for it to turn back (crossover occurs) 3. Enter trade in direction of turn 4. Use other analysis for confirmation [EXAMPLE] Stock in uptrend pulls back. Stochastic drops to 15 (oversold), then %K crosses above %D. This is a buy signal—momentum turning up from oversold in an uptrend. **Stochastic Divergence:** Same concept as RSI divergence: - Price new high + stochastic lower high = bearish divergence - Price new low + stochastic higher low = bullish divergence ### Fast vs. Slow Stochastic **Fast Stochastic:** - More sensitive, more signals - More false signals - Better for scalping **Slow Stochastic:** - Smoothed, fewer signals - More reliable signals - Better for swing trading [KEY] Most traders use the slow stochastic to reduce noise and false signals. ### Combining Stochastic with Trend **In uptrend:** - Buy oversold readings - Ignore overbought readings (trend can stay overbought) **In downtrend:** - Sell overbought readings - Ignore oversold readings (trend can stay oversold) [WARNING] Don't trade stochastic blindly. An oversold reading in a strong downtrend can get more oversold. Always consider the overall trend. [EXERCISE] A stock is in a clear downtrend. Stochastic shows %K at 85 crossing below %D at 88. What signal is this, and is it tradeable? |ANSWER| This is a bearish crossover in overbought territory. Combined with the downtrend, it's a strong short signal—momentum turning down from overbought in a bearish trend. Enter short with stop above recent high. [SCENARIO] You're watching a stock in an uptrend. Stochastic has been above 80 for two weeks while price keeps rising. Someone tells you it's "overbought" and due for a fall. Is this accurate? Not necessarily. In strong uptrends, stochastic can "embed" above 80 for extended periods. Being overbought doesn't mean a stock will fall—it just means it's been strong. Wait for actual signals (divergence, crossover back below 80) rather than selling just because it's been overbought.