What are Stochastic Oscillators?
Stochastic Oscillator is a popular technical analysis indicator that provides additional information about momentum and trend strength. Developed by George Lane in the 1950s, the indicator analyses price movements and in return, tells you about the speed and strength of price moves.
The momentum oscillator is based on two main principles:
- In an uptrend, prices will always remain equal or above the previous price close
- In a downtrend, the price will always remain equal or below the previous price close
In trading charts, the Stochastic Oscillator appears as two lines, one representing the actual value of the oscillator at a given period. The other line represents the simple moving average. The intersection of the two lines often signals a potential trend reversal.
The indicator relies on a scale to measure the rate at which price changes over time, to predict the continuation of a trend. The indicator is scaled from 0 to 100. Any movement past the 80 level is most of the time associated with overbought market conditions, while movements below the 20 line usually signal oversold market conditions.
That said, the indicator moving past the 80 and 20 level does not all the time signal a potential price reversal. Depending on the strength of the uptrend or downtrend, the price of an underlying equity might remain in oversold or overbought conditions for prolonged periods of time. For this reason, it is important to use stochastic indicators to look for clues about potential future trend changes.
As the indicator oscillates between 0 and 100, 50 acts as the centerline that chartists use to identify new trend formation. Whenever the momentum oscillator crosses the centerline from below, that signals development of an uptrend, especially if the price is coming from oversold conditions. Conversely, whenever the indicator crosses the centerline from above, chartists interpret that as a downtrend formation, especially in situations where the price is coming from overbought conditions.
Stochastic Indicator Divergence
In addition to signalling overbought and oversold market conditions, the Stochastic Oscillator is an ideal technical analysis tool for determining price reversals. The divergence between the indicator and the underlying price action at times signals a reversal signal.
When a downtrend reaches a new lower low acting as solid support, the oscillator might print a higher low indicating exhaustion of the prevailing bearish trend. What would happen most of the time is that the price might bounce back and start edging higher as part of a new uptrend.
Conversely, upon the price of an underlying asset reaching a new all-time high, the stochastic indicator might print a lower high, signalling waning bullish momentum. In such cases, the price might start pulling lower as bulls exit positions and sellers assume control.
Whenever a stochastic indicator accelerates in one direction resulting in widening of the two bands, then the same can be interpreted as the start of a new trend, signalling a breakout from a trading range.
Stochastic Oscillator vs. Relative Strength Index
While the Stochastic Oscillator and the Relative Strength Index are both price momentum indicators, they differ in the way they operate and the results they provide. While the stochastic oscillator assumes that closing prices should close above or below the current trend, RSI tracks overbought and oversold conditions by measuring the velocity of price movements.
Like the Relative Strength Index, the indicator is ideal for measuring the speed of price movements as the stochastic oscillator provides information for trading ranges.