One of the most known and popular Oscillator indicators is the Stochastic Oscillator. The core principle of this indicator is the normalizing position of current price relatively to the chosen period.
The Stochastic Oscillator Technical Indicator compares where an asset price had closed, relatively to its price range over a given period. The Stochastic Oscillator consists of the two lines; the main line %K and signal line %D. Main Line %K is the Oscillator line itself, and the Signal line %D is a Moving Average of %K line. The %K line is a solid line and the %D line is typically depicted as a dotted line.
According to the interview with the developer of the Stochastic Oscillator George C. Lane, the Stochastic Oscillator “doesn’t follow price; it does not follow volume or anything like that. It follows the speed or the momentum of price. As a rule, the momentum changes direction before price.” To conclude, bullish and bearish divergences between price and the Stochastic Oscillator can indicate reversals in price movements; Divergences was the first, and most important, signal that G. C. Lane identified. Nevertheless SO widely used to confirm formations of the trend and track overbought and oversold states of the market.
The Stochastic Oscillator is a momentum indicator that uses support and resistance levels. Dr. George Lane developed this indicator in the late 1950s. The term stochastic refers to the point of a current price relative to the price range over a period. This method attempts to predict price turning points by comparing the closing price of an asset to its price range for the particular period. Dr. George Lane, a financial analyst, is one of the first to publish on the use of stochastic oscillators to forecast prices. According to Lane, the Stochastics indicator is to be used with cycles, Elliot Wave Theory and Fibonacci retracement for timing.
The Stochastic Oscillator has four variables:
%K periods – this is the number of time periods used in the stochastic calculation;
%K Slowing Periods – this value controls the internal smoothing of %K. A value of 1 is considered a fast stochastic; a value of 3 is considered a slow stochastic;
%D periods – this is the number of time periods used when calculating a moving average of %K;
%D method – the method that is used to calculate moving average for %D (i.e., Exponential, Simple, Smoothed, or Weighted);
The formula for %K:
%K = (CLOSE-LOW(%K))/(HIGH(%K)-LOW(%K))*100;
CLOSE — is current par closing price;
LOW(%K) — is the lowest low for the Stochastic Period;
HIGH(%K) — is the highest high for the Stochastic Period;
Formula for the %D moving average:
%D = SMA(%K, N)
N — is the smoothing period;
SMA — is the Simple Moving Average.
How to use it
The cornerstone idea behind the oscillators is to normalize price position regarding previous price movements. There are many methods and trading strategies based on the Stochastic Oscillator. The most common strategies are Turning points, Following the trend, Divergences.
Up-Down turning point: Buy when the Oscillator line %K falls below a specific level (e.g., 20) and then rises above that level;
Down-Up turning point: Sell when the Oscillator rises above a specific level (e.g., 80) and then falls below that level;
As seen on the graph, indicator produce many trading signals. One disadvantage of such method – significant lag of the signals. Second – significant portion of false signals during low volatile periods.
Follow the trend
Buy when the %K line rises above the %D line and sell when the %K line falls below the %D line;
Unlike the previous method, this approach seems much more sensitive to the market behavior. As well we get a lot of false or non-profitable signals. The well-known weak spot of Stochastic Indicator is quiet periods (low volatile). During such periods, indicator produces lots of false signals.
Look for divergences. For instance: where prices are making a series of new highs and the Stochastic Oscillator is failing to surpass its previous highs.
EURUSD rallied to make a higher high; however, the Stochastic indicator failed to make a higher high. Instead, it made a lower high. This divergence coupled with a trend line breakthrough may have acted as a strong warning to futures traders that the recent rally had probably ended, and any long positions might be closed or at least scaled back.