What is the Stochastic Oscillator?
The Stochastic Oscillator compares the current closing price to the range between the highest and lowest prices over a defined period (usually 14 candles) and displays the result on a scale from zero to one hundred. This indicator consists of two lines, %K and %D, where %D is essentially a moving average of %K.
How it's calculated
The %K line comes from the formula (closing price minus the lowest price of the period) divided by (the highest price of the period minus the lowest price of the period), multiplied by one hundred. The %D line is usually a 3-period simple moving average of that same %K line, used to smooth out its fluctuations.
How to read the chart
A reading above 80 is considered the overbought zone, and below 20 is the oversold zone. Unlike RSI, which works based on the gains and losses of candles, the Stochastic Oscillator purely measures the current price's position relative to its recent range, which is why it reacts faster to price changes.
Trading signals
A crossover between the %K and %D lines in the overbought or oversold zones is this indicator's most common signal; %K crossing from below to above %D in the oversold zone is considered a bullish signal, and the reverse crossover in the overbought zone is considered a bearish signal. Divergence between the Stochastic Oscillator and price can also signal a weakening trend.
Strengths and limitations
Because of its high sensitivity, the Stochastic Oscillator produces early, useful signals in ranging markets, but that same sensitivity means it generates a lot of noise and false signals during strong trends.
Practical tip
In strong uptrends, it's better to pay attention only to the Stochastic's bullish signals and ignore its bearish ones, which go against the main trend direction; the same rule applies in reverse for a downtrend.