The stochastic oscillator was developed in the late fifties by George Lane. It is an oscillator which shows momentum in a commodity by comparing the current day?s close to the high/low ranges over a specified amount of days. Consistent closings near the higher side of the range indicates buying pressure while a close consistently on the lower side of the range indicates weakness and selling pressure. It shows whether a commodity is overbought or oversold. The calculation of the formula is as follows:
%K = (Recent Close-Lowest Low (n) / Highest High (n) ? Lowest Low (n)) x 100
%D = 3 period moving average of %K
And (n) = the number of periods used for calculations
Hence, a 20 day stochastic oscillator would take the most recent close, the highest high of the last 20 days as well as the lowest low of the last 20 days. The general time period used here is the 14 time period. These formulas are given here for clarification only. One rarely ever needs to calculate these values manually, as the software used for charting will automatically plot it straight on your commodities chart.
Stochastic Oscillator – How Do We Use It?
Essentially, Stochastic Oscillators have three types. Fast, full and slow. By default, most trading software tends to use the fast one. Here, the oscillator comprises of two lines. The first one is %K which measures the raw momentum of the commodity. As discussed earlier, %D is just a simple moving average of %K, but is still more important than %K. Generally, it is seen that the %K line is the faster line, and the %D line is the slower one. A trader needs to look out for %D line and price both moving to either overbought territory, or the oversold territory. One can sell the commodity when it moves above 80, and then crosses over to begin moving down again and buy when it reaches 20 and begins to move up again. The slow or full stochastic oscillators are smoother, as compared to the fast stochastic. However, it is important to remember that just because the oscillator shows that it is above 80 does not mean that it is overbought. It may well continue to trend upwards a long time after that.
Sometimes, something unusual happens. There is sometimes a divergence between the prices and the stochastic oscillator. When prices are moving up the oscillator is showing that it is oversold, and vice versa. This tells us that the current trend is losing steam. So, if the commodity moves up, but the %D is going down, this would be a bearish sign. However, it must be noted that the signal is not considered a divergence till %K line moves across the %D line in a direction opposite to the price. One has to be careful with the stochastic oscillator as there are a lot of whipsaw possibilities. Divergence trades are best taken when the oscillator moves below 80 once, moves back up again, and gives a double top formation to move down again below 80.
It is not advised to use this oscillator by itself. It is always better to get verification from as many different indicators, but this indicator will give you a very good idea about the trend momentum of a commodity.
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