Back to Basics: Understanding the Stochastic Oscillator

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What is the Stochastic Oscillator?

The Stochastic Oscillator was developed in the late 1950s by George Lane (though some attribute its creation to Ralph Dystant). This indicator shows the location of the close relative to the high-low range over a set number of periods, and is commonly used in technical analysis.

The Stochastic Oscillator comprises two lines: a main line called %K and a secondary line called %D.

The indicator is built with three variables (x, y, z), tied to the formulas used in its construction. The most commonly used settings are (14, 3, 3) and (5, 3, 3).

The formula for the %K line is as follows:

%K = (C – L) / (H – L) * 100

where C is the latest closing price, L is the lowest price over the past x periods, and H is the highest price over the same x periods.

Typically, the raw %K values are not used directly as they react sensitively to price changes. Therefore, traders often smooth the %K line by calculating the MA(y) of the %K line and plotting this smoothed line instead.

The second line, %D, is the MA(z) of the %K line. In other words, %D is a smoothed version of %K, meaning it is the MA of the MA of the original %K line.

Using the above formulas, you can construct the Stochastic Oscillator, as shown in the example below.

Characteristics of the Stochastic Oscillator

Lane asserted that the Stochastic Oscillator does not follow price, volume, or anything similar, but rather the speed or momentum of price. According to the theory, momentum or price speed changes before the price itself changes. Hence, this indicator is categorized as a leading indicator, unlike lagging indicators.

As a momentum indicator, the Stochastic Oscillator also reveals the speed at which price changes, whether fast or slow.

The indicator’s values always range between 0 and 100, making it useful for identifying overbought and oversold conditions. Generally, values above 80 are considered overbought, and values below 20 are considered oversold. However, when the indicator reaches overbought or oversold levels, it does not always signal an imminent reversal, as strong trends can maintain these conditions for extended periods.

In the most recent gold rally, the Stochastic stayed above the oversold region,but price only reversed once the Stochastic exited this zone.

Divergence between the Stochastic Oscillator and price action is also considered a significant reversal signal. For example, if the price is in a downtrend making lower lows, but the oscillator makes higher lows, it could indicate that the bears are losing strength and a bullish reversal may be on the horizon.