A Technical Analyst, Trader, and Educator named George Lane developed Stochastic Oscillator in the 1950s. This indicator also called Lane's Stochastic, since then, has become incredibly popular among traders and analysts and forms one of the core indicators in several trading strategies. For me, it is one of the indicators that I use in my swing trading strategies.
Let's get into the details of this indicator in the paragraphs that follow.
What is a Stochastic Oscillator?
A Stochastic Oscillator is a momentum indicator that shows the speed with which the prices are moving. This oscillator oscillates between 0 and 100 and thus also shows the overbought and oversold regions of a stock.
This indicator is based on idea that in an uptrend the stock price tends to close near high while in a downtrend the price tends to close near low.
This forms the principle behind the Stochastic oscillator. A stochastic oscillator depicts the close of a stock in relation to the range for a particular period.
The principle behind Stochastic Oscillator -
The Stochastic oscillator compares the closing of a stock or security with respect to the range of price movements over a period.
The difference between the highest price in the 14 days ( the default stochastic period) and the lowest price in the 14 days is the range of this period. Now if the closing price is near the high of 14 days period, that is, on the upper side of the range, we say that the stock is in an uptrend, since in an uptrend the closing price tends to be near the high.
This fundamental observation forms the principle behind the stochastic oscillator.
Now that you have a basic idea about the stochastics let's move further to the calculation part.
Calculation of Stochastic oscillator
A stochastic has two lines which are depicted as %K and %D.
%K = 100* (CLOSE - 14 DAY LOW) / (14 DAY HIGH - 14 DAY LOW)
Once you have arrived at the value of %K, %D is calculated as 3 period moving average of %K.
Fast Stochastic and Slow Stochastic-
The calculation that we learned above is of Fast Stochastic. However, some traders felt that the fast stochastic was exceedingly responsive to price movements and gave many signals that resulted in many whipsaws. To counter this drawback the idea of slow stochastic was conceptualized.
In the slow stochastic % K line was smoothed through the 3-period moving average and then it was further smoothed through 3-period MA to arrive at the %D value.
So, in a slow stochastic-
%K (Slow Stochastic) = 3 period MA of %K of fast stochastic
%D (Slow Stochastic) = 3 period MA of %K (Slow Stochastic)
Interpretation of Stochastic Oscillator
As stated earlier, stochastic has two lines called % K and % D lines. Also, a stochastic chart has two marked levels at 20 and 80. See it in the chart below-
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| Chart showing interpretation of Stochastic. (Click to enlarge) |
In the chart of NIFTY shown above, a stochastic has two lines. The %K line is shown in green and the %D line is shown in red.
%K line crossing above the %D line is considered a buy signal while %K line going below the %D line is seen as a sell signal.
However, like all other indicators stochastics should not be used in isolation for trading, and other factors like trend direction and other indicators should be used in conjunction to make better trading decisions.
Apart from giving buy and sell signals stochastics also shows the overbought and oversold levels (Like RSI) of a stock as shown in the chart above.
Stochastic levels above 80 are suggestive of a stock being overbought and levels below 20 indicate a stock is oversold.
Bear in mind though overbought is not a sell signal as stochastic can remain above 80 for a long period, especially in strong trends. Conversely, an oversold level on stochastic is not a buy signal as in a strong downtrend the stochastic can remain below 20 for an extended period.
Practical uses of Stochastic Indicator-
Now that we have fundamentals of stochastic indicator, let's move on to practical uses of stochastic.
Stochastic Crossovers-
As discussed earlier, a buy signal is generated when the %K line moves above the %D line, however, this strategy generates many false signals when used in isolation.
One of the ways to screen out such false signals is by pairing it with trend direction.
In this method, we first ascertain the trend direction and then take only those signals that are in agreement with the overall trend.
I use a combination of two SMAs—a 21-period SMA and a 50-period SMA—to ascertain the trend direction. A 21-period SMA above the 50 EMA tells us that the stock is in an uptrend. Then for an up trending stock, we go for a buy when the %K line crosses above the %D line near the oversold level. In a stock in an uptrend, we ignore all sell signals.
The left hand Vs The right hand crossovers.
George Lane described two kinds of crossovers while describing stochastic crossovers. A left hand crossover happens when the %K line crosses above or below %D line while %D line still going in towards the overbought/ oversold region.
Conversely, a right hand crossover happens when %K line crosses above or below %D line while %D line has changed its direction away from overbought/oversold region. (Source)
A right hand crossover is more reliable as described by George Lane.
Let's understand this through the chart below.
In this daily chart of ICICI, the stock is in an uptrend, as the 21-period SMA (shown in green in the price chart) is above the 50-period SMA (shown in red). Now as shown in the chart above we would take only buy signals and ignore all sell signals. We would go for a buy when the %K line crosses above the %D line near the oversold region. Notice in the chart above that stochastic gives many valid buy signals as marked by arrows.
Price Stochastic divergences-
Another practical use of stochastic is by spotting Divergences. A divergence happens when the price makes a lower low but stochastic makes a higher low and vice versa (Just like an RSI divergence). A divergence between price and Stochastic tells that the prevailing trend is losing momentum and a reversal might be on the cards.
You don't enter a trade immediately after spotting a divergence. Rather you wait for a confirmation. The confirmations can be-
- A significant candlestick reversal pattern
- A trendline break
- A stochastic crossover and stochastic lines coming out of overbought and oversold region.
The chart above is a daily chart of INFY. Notice on the left-hand side of the chart that the price of the stock is going down. Between March and April 2023 the stock makes a lower low but stochastic makes a higher low in the same period suggesting a positive divergence.
The entry point has been marked at the point where %K crosses above oversold zone. Notice also that a bullish hammer candlestick pattern has formed near divergence. The stock price goes up subsequently.
The Bull and Bear stochastic setups
George Lane, who developed the Stochastic Oscillator, described another kind of divergence which he described as 'set-ups'.
A set-up is more like hidden divergence.
In a bullish set-up, the price makes a lower high but the stochastic oscillator makes a higher high in a downtrend. A higher high in stochastic suggests a strengthening momentum on upside. Once a set-up is spotted you can go long once the %K line crosses above the %D line near the oversold region. (Source)
Let's understand this through a chart.
The Bottom Line-
-The Stochastic is a momentum oscillator which oscillates between 0 and 100.
-A level above 80 suggests a stock is overbought and a level below 20 suggests the security is oversold.
-A stochastic has two lines called %K and %D lines.
-The Crossover of the %K line above and below the %D line gives buy and sell signals respectively.
-By aligning the buy and sell signals with the existing trend, better trading decisions can be made.
-Stochastic can also predict shifts in momentum through divergences and set-ups.
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