1. What is a Stochastic Oscillator?

The Stochastic Oscillator is an indicator developed by George Lane in the 1950s. Its basic logic is to compare the closing price of a financial asset with the price range over a certain time period.

Main Assumption:

  • Prices typically close near the top of the range in an uptrend and near the bottom in a downtrend.

This indicator contains two lines:

  • %K: Main line (often called fast stochastic).

  • %D: Moving average of the %K line (signal line).

Stochastic Oscillator

2. How Does the Stochastic Oscillator Work?

The oscillator produces a value between 0 and 100. This value indicates whether prices are in overbought or oversold territory.

General Comment:

  • 80 and above: Overbought (potential selling opportunity).

  • 20 and below: Oversold (potential buying opportunity).

  • The intersections of the %K and %D lines can be interpreted as trend reversal signals.

Divergences (Incompatibilities):

  • If the price makes a new high but the oscillator fails to do so, this could be a bearish signal.

If the price makes a new low but the oscillator fails to do so, this could be a bullish signal.

STOCHASTIC OSCILLATOR

3. How to Calculate Stochastic Oscillator?

Stochastic oscillator calculation consists of three steps:

Step 1: Calculating %K

%K= (Closing Price − Lowest Price) / (Highest Price – Lowest Price) * 100

  • Closing Price: The last price for a given period.

  • Lowest Price: The lowest price during a specified period.

  • Highest Price: The highest price during a given period.

Step 2: Calculating %D

The moving average of %K is taken:

\%D = \text{n-period moving average(%K)}

Step 3: Time Range Selection

  • The standard setting is usually 14 periods (for example, 14 days of price data).

  • This setting can be changed by the user.

4. Advantages and Disadvantages

Advantages:

  • Simple and easy to apply.

  • Effective in identifying momentum and overbought/oversold zones.

  • Can be used in different time zones.

Disadvantages:

  • Can generate false signals (especially in sideways markets).

  • It may be misleading if not supported by other indicators.

5. Application Area and Strategies

Basic Strategies

  • Cutting Strategy: Watch for the intersection of the %K and %D lines.

  • Overbought/Oversold Strategy: Consider entering a trade when readings move below 20 or above 80.

  • Divergence Strategy: Watch for divergences between price and oscillator.

In Which Markets Is It Used?

  • It is frequently used in volatile markets such as stocks, currency pairs, commodities and cryptocurrencies.

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