The Stochastics oscillator or the Stochastics indicator as it is widely known is a momentum indicator.
Depending on how one uses it, the Stochastics oscillator can also determine the trend strength. The oscillator also goes by other names such as the %K or the %D oscillator.
Many traders use the Stochastics oscillator simply as an overbought or an oversold indicator, but there is more to this. It is essential to understand how an indicator works because it helps you to get more context about the markets.
Stochastics Oscillator by George C. Lane
The Stochastics oscillator was developed by George C. Lane and a few others in the 1950s. The name of the indicator comes from the mathematical concept of randomness and probability. Thus, the process of Stochastics is the description of the movement over a period of time.
While the oscillator does not describe the movement of the price, it tells you what the price can do.
The Stochastics oscillator measures the momentum. The momentum is nothing but the rate at which the price is rising or falling. The reason behind measuring momentum is that it always precedes changes in the price direction.
For example, you can see price rising sharply when the momentum is strong. Conversely, when the momentum slows, the rate of increase in the price also declines. Thus, by measuring momentum, traders can anticipate potential changes in price.
The Stochastics oscillator can also be used to measure trends.
How Does the Stochastics Oscillator Work?
The Stochastics oscillator is made up of two lines, the %K (the fast line) and the %D (the slow line).
Mathematically, they are represented as:
%K = 100 x [(C-Lx close)/(Hx – Lx)]
%D = 100 (Hy – Ly)
The x and y are nothing but the values. For example, a Stochastics of 5,3 implies that x = 5 and y = 3. Depending on what trading platform you use, the Stochastics values can be three variables as well. Common examples include the 5, 3, 3 or the 14, 3, 3 settings.
The former is known as the Fast Stochastic, while the latter is known as the Slow Stochastic. The only difference between the two is that the indicator is either very sensitive or less sensitive.
By applying the factor of 100, the oscillator is made to move within the range of 0 and 100, where the 80 and the 20 levels are called the oversold and overbought levels.
How to Use the Stochastics Oscillator
Many traders automatically think of the stochastics oscillator as an indicator that will show the overbought and oversold levels. But this is just one way of using the indicator.
Depending on whether the markets are ranging or trending, the overbought and oversold levels can take on different meanings.
During a trending market such as an uptrend, the stochastics tends to mover from oversold to overbought levels. These reflect the correction or the dips in the rally. When the momentum is strong, the stochastics oscillator can remain in the oversold levels for prolonged periods of time.
The same holds true when the markets are in a downtrend. Besides moving from overbought to oversold levels, the oscillator can remain in the oversold level for prolonged periods of time. This does nothing but reflect the strength of the momentum.
Using the moving averages as a gauge for the trend, traders can buy into the dips in an uptrend or sell the rallies in a downtrend.
Divergence is another way of using the stochastics oscillator. When the oscillator fails to make the new highs and lows in price, a divergence is formed. The divergence potentially indicates when price could make a steep correction.
Why You Should Use It
If you are trading with the trend, the stochastics oscillator can help you to understand what price is doing. Depending on the strength of the trend and where the stochastics oscillator is, traders can estimate whether the prevailing trend can continue.
Similarly, when the markets are ranging, you can use the stochastics oscillator’s overbought and oversold levels to trade the sideways range. But note that this is not always in sync and it takes quite a bit of practice.
Lastly, using the stochastics as a divergence tool can alert you to potential changes or corrections in the trend.