Designed by George C. Lane in the late 1950s, the Stochastic Oscillator is a momentum indicator that reveals the position of the close relative to the high-low range with a set number of periods.

It follows the rate or the momentum of price. Customarily, the momentum changes direction before price. Therefore, bullish and bearish divergences in the Stochastic Oscillator may be used to predict trend changes. It was the first, and most vital, alert that Lane uncovered. Lane also used this oscillator to spot bull and bear set-ups to predict a future reversal. As the Stochastic Oscillator is range bound, it can be great for determining overbought and oversold levels.

Probably the most commonly used setting for the Stochastic Oscillator is 14 periods, which could be days, weeks, months or an intraday timeframe. A 14-period %K will make use of the most recent close, the highest high over the last 14 periods and the lowest low over the past 14 periods. %D is a three day simple moving average of %K. This line is drawn along with %K to act as a signal or trigger line.

Buy and sell signals manifest in case the %K crosses through a 3 period moving average called the %D.

Should the Stochastic is above 80, a stock or market is overbought.

If the Stochastic remains above 80 it means the uptrend is strong.

In case the Stochastic falls below the 80 level, anticipate a downward correction or the beginning of a new downtrend.

In case the Stochastic falls underneath 20, a stock or market is oversold.

Should the Stochastic stays below 20, it means the downtrend is strong.

As soon as the Stochastic climbs above 20, anticipate an upward correction or the beginning of a new uptrend.

There are various trading methods for use with the Stochastic Oscillator but the best is the Overbought Oversold system.

First establish the bigger trend in the stock or market you are trading.

Make your Stochastic overlay using the Full Stochastic and a setting of 14 and 3.

The Stochastic provides a buy signal when it rises above the 20 line.

It gives a sell signal when it breaks below the 80 line.

One other popular trading technique which uses the Stochastic Oscillator is known as the Crossover method.

Should the %K line from above crosses the %D line downwards this is the sell signal.

Should the %K line from below crosses the %D line upwards, this is a buy signal.

Stochastic line crossovers that take place above the 80% level and below the 20% level are thought of as the most effective signals in comparison with crossovers outside these areas.

Swing traders may wish to increase the sensitivity of the Stochastic Oscillator by using a 5,3 setting which is more effective for trading rapidly changing markets.

The third hottest way of trading with the Stochastic Oscillator is called the Divergence method.

If the price of a stock is making new highs but the Stochastic is hitting new lows, a negative divergence has taken place and it means the cost of the stock will probably fall.

Should the price of a stock is making new lows but the Stochastic is making new highs, a positive divergence has taken place and it means the price of the stock is likely to jump higher.

The aim of this strategy is to locate a divergence regarding the price of a stock and the Stochastic Oscillator.

Author Bio: Lance is a 20 year technical analyst and educator. For a humorous look at the stochastic indicator drop by stochastic indicator

Category: Finances
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