A stochastic oscillator is a popular technical indicator used for identifying overbought and oversold stock/asset/cryptocurrency levels that rely on an asset's price history, as it tend to fl
What Is a Stochastic Oscillator?
Stochastic oscillator is a momentum indicator that is used to determine the time of entry and exit in a trade depending on whether the fundamental financial instrument is overbought or oversold.
The concept of stochastics was created by Dr. George Lane in the 1950s, which involved comparing the current price to a price range for a specific amount of time.
The stochastic oscillator displays the position of a stock's closing price in respect to its high and low range over (generally) 14 days. According to Lane, the stochastic oscillator does not change in relation to price, volume, or other factors, rather Lane claims that the oscillator tracks the price's pace or momentum.
The graph of a stochastic oscillator usually consists of two lines, named K and D:
One line shows the oscillator's real value for each period.
The other line reflects the three-day simple moving average.
The crossing of these two lines is taken as an indication that a reversal is imminent, as it shows a significant movement in momentum on a day-to-day basis.
Why Is Stochastic Indicator Used?
The stochastic indicator is used to gauge the ongoing market sentiment. It is programmed to provide values between 0 and 100, with readings closer to 0 suggesting a bearish condition and readings closer to 100 indicating a bullish state. Unlike other crypto trading indicators, the stochastic indicator does not show negative readings or numbers greater than 100.
Stock/Crypto traders commonly utilize the numbers 20 and 80 as key thresholds. Any values below 20 imply that the market is oversold, while anything above 80 suggests that it is overbought. Keep in mind that the indicator still shows overbought or oversold circumstances when it reaches values much above or below 80 and 20. It may not always imply that a reversal is taking place.
As mentioned above, divergences occur when the Stochastic Oscillator fails to establish a new price high or low. A bullish divergence occurs when the price makes a lower low while the Stochastic Oscillator produces a higher low which indicates a decrease in negative momentum, which might indicate a good turn. When the price makes a higher high while the Stochastic Oscillator makes a lower high, this is known as a bearish divergence.
What Is the Best Setting for a Stochastic Oscillator?
The ideal settings for Stochastic Oscillator is the following:
%K Length: 14
%K Smoothing: 3
%D Smoothing: 3
Stochastic Oscillator Formula
Here’s how you can calculate the Stochastic Oscillator:
H14 = Highest price during the last 14 periods
%K Slowing Period = The current value of stochastic indicator3
For example, comparing RSI with stochastic oscillator, it can be noticed that the stochastic oscillator works on the assumption that closing prices should reflect the current market trend. Meanwhile, the RSI measures the velocity of price changes to identify overbought and oversold levels. The RSI is generally more beneficial in growing markets, whereas stochastics are more helpful in sideways or turbulent markets.