Stochastic Oscillator

A stochastic oscillator is a momentum indicator that compares a closing price index of a hedge to a range of its values over a given period of time. The sensitivity of the oscillator to market movements can be reduced by adjusting that period of time or taking a moving average of the result. It is used to generate overbought and oversold trading signals, using a 0–100 limit of values.

Stochastic Oscillator is developed by George C. Lane in the late 1950s, the stochastic is a momentum oscillator that compares a security’s closing price to its price range over a given time period. Closing levels that are consistently near the top of the range indicate accumulation (buying), while those near the bottom of the range indicate distribution (selling).

Stochastic is made up of two lines, one first line and the other slow, crossing over one another and regularly oscillating between the minimum of 0% and the maximum of 100%. These two lines are known as the %K Line and the %D Line.

The %K Line is the faster of the two and the %D line is the slower one. Based on the method of the construction used, the %D Line will always lag behind the %K Line. Also, %K and %D lines would take values between 0 and 100. Readings above 80% are considered overbought, while those below 20% signal an oversold condition. But this should not be taken as a fixed commandant. Prices can sometimes continue to rise even after the stochastic oscillator has reached 80, and continue to fall even after the stochastic oscillator has reached 20:

• Buy signals are generated when both lines are in oversold territory (below 20%), and the fast line crosses back above the slow line and then rises above 20%.
• On the other hand, sell signals are generated when both lines are in overbought territory (above 80%), and the fast line crosses below the slow line, dropping below 80%.

According to George C. Lane , some of the best signals usually occur when the oscillator moves from overbought territory back below 80, and from oversold territory back above 20. 

It is usually prudent to wait for divergences to develop from overbought or oversold levels.

Trading decisions can also be taken when the overbought reading is above 70 and the oversold reading is below 30. The best buy signals are generated when the stochastic is below 15 and the best sell signals when it is above 85. The reading of %D are generally used for identifying the overbought and oversold zones. In fact, the entry of the %K line into the overbought or oversold  zones is an early warning of the possibility of %D line following suit.

The stochastic oscillator, also known as stochastic, is a popular trading indicator useful for predicting trend changes. It also focuses on stock prices and can be used to denote oversold and overbought in shares, indexes, currencies and many other investment assets.

The stochastic oscillator measures the momentum of price movements. Momentum is the measure of speed to cost of action. The assumption behind the stochastic indicator is that the price strength of the instrument will usually change before the action of the instrument indicators changes. As a result, the signal can be used to detect changes in climate change.

Phase of Market  to Use In 

Stochastic oscillator is used in Trading / Sideways / Consolidation / Range Bound Markets.

Trading Rules and Setups

• Go long on bullish divergence (on %D) where the first trough is below the oversold level.
• Go long when %K or %D falls below the oversold level and then rises back above it.
• Go long when  %K crosses above %D.
• Go short on bearish divergence (on %D) where the first peak is above the overbought level.
• Go short when %K or %D rises above the overbought level and then falls back below it.
• Go short when %K crosses to below  %D.
• Place a stop below the most recent minor low when going long – or above the most recent minor high when going short.
• %K and %D lines pointed in the same direction are used to confirm the direction of the short term trend.

• Do not go long when overbought, nor short when oversold. Use trailing buy and sell stops to enter trades and protect yourself with stop loss.
• Go long: If %K or %D falls below the oversold line, place a trailing buy stop. When you are stopped, place a stop loss below the low of the recent down trend (the lowest low since the signal day.)
• Go short: If stochastic rises above the overbought line, place a trailing sell stop. When you are stopped, place a stop loss above the high of the recent up trend (the highest high since the signal day). 
• Use a trend indicator to exit.