The Stochastic Oscillator
Today I’m going to introduce to you to the stochastic oscillator. The stochastic oscillator is a momentum indicator that shows the position of the most recent closing price relative to the previous high-low range. It follows the speed and momentum of the price. The stochastic oscillator changes direction before the price itself, and can therefore be considered a leading indicator.
Dr. George Lane developed this indicator in the late 1950s. Over 60 years later, the stochastic oscillator remains one of the most popular indicators in technical analysis. The most important signals that form the stochastic indicator are the bullish and bearish divergences. This is how price level reversals are anticipated. The stochastic indicator can also be used to identify overbought and oversold price levels.
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Understanding the Stochastic Oscillator
The stochastic oscillator is range-bound meaning it is always between 0 and 100. A stochastic oscillator generally consists of two lines: one reflecting the actual value of the oscillator, and one reflecting its three-day simple moving average. Because price is thought to follow momentum, intersection of these two lines is considered to be a signal that a reversal may be in the works, as it indicates a large shift in momentum.
The default setting for the stochastic oscillator is 14 periods, which can be days, weeks, months or an intraday time frame. A 14-period %K would use the most recent close, the highest high over the last 14 periods and the lowest low over the last 14 periods. %D is a 3-day simple moving average of %K. This line is plotted alongside %K to act as a signal or trigger line.
Overbought and Oversold
The stochastic oscillator can be used to identify overbought and oversold market condition. You can see each of these scenarios in the example below.
Low readings (below 20) indicate that price is near its low for the given time period and oversold market conditions. High readings (above 80) indicate that price is near its high for the given time period and overbought market conditions.
It is important to note that oversold readings aren’t always bullish and overbought readings are not always bearish. During a prolonged uptrend or downtrend, the stochastic indicator can remain in an the oversold or overbought area for a long period of time. It is advised to trade in the direction of the trend and wait for oversold readings during uptrend and overbought readings during the downtrend.
Closing levels consistently near the bottom of the range indicate sustained selling pressure. Therefore, it is important to identify the bigger trend and trade in the direction of this trend.
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Look for occasional oversold readings in an uptrend and ignore frequent overbought readings. Similarly, look for occasional overbought readings in a strong downtrend and ignore frequent oversold readings.
Bullish and Bearish Divergences
Divergences form when a new high or new low price level is not confirmed by the stochastic oscillator.
A bullish divergence forms when price records an equal swing low or makes a new lower low, but the stochastic oscillator forms a higher low. This shows less downside momentum that could foreshadow a bullish reversal.
Once a bullish divergence is under way, traders should look for a confirmation to signal an actual reversal. A bullish divergence can be confirmed with a resistance break on the price chart or a stochastic oscillator break above 50.
A bearish divergence forms when price records an equal swing high or makes a new higher high, but the stochastic oscillator forms a lower high. The chart below shows less upside momentum that resulted in a bearish reversal.
Once a bearish divergence is under way, traders should look for a confirmation to signal an actual reversal. A bearish divergence can be confirmed with a support break on the price chart or a stochastic oscillator break below 50.
The stochastic 50 level is an important level to watch. The stochastic oscillator moves between zero and one hundred. A stochastic oscillator cross above 50 signals that prices are trading in the upper half of their high-low range for the given look-back period. This suggests that the cup is half full. Conversely, a cross below 50 means that prices are trading in the bottom half of the given look-back period. This suggests that the cup is half empty.
The stochastic oscillator can be used to identify turns near support or resistance.
Should a security trade near support with an oversold stochastic oscillator, look for a break above 20 that will signal an upturn and successful support test.
Conversely, should a security trade near resistance with an overbought stochastic oscillator, look for a break below 80 that will signal a downturn and resistance failure.
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Divergences identify potential reversals or bigger corrections. In an established downtrend, if we’re seeing bullish divergence in the stochastic oscillator then that indicates a potential reversal or deeper pullback in the trend. Conversely, if we’re seeing bearish divergence in an established uptrend then that would likely indicate a potential reversal or deeper correction within the uptrend.
Hopefully, this will remove any reservations about how to use the stochastic oscillator.