In technical analysis of securities trading, the stochastic oscillator is a momentum indicator that uses support and resistance levels. Dr. George Lane developed this indicator in the late 1950s. The term stochastic refers to the point of a current price in relation to its price range over a period of time. This method attempts to predict price turning points by comparing the closing price of a security to its price range.
Developed and introduced by George C. Lane in the 1950s, the Stochastic Oscillator is a valuable momentum indicator or investment analysis tool. This tool is devised to measure and compare the closing price of a given security to its potential price range over a stated time period.
The sensitivity of Stochastic Oscillator to the movement of the market can be significantly lowered by computing its moving average or adjusting its time period. The formula used for computation is
%K = 100[(C – L14) / (H14 – L14)]
C is defined as the latest closing price
L14 is the lowest trading price in the past 14 day trading session
H14 is the highest trading price during that same 14 day trading period
%D is 3 period moving average (MA) of %K
Stochastic Oscillator’s default setting is fourteen periods. This can either be 14 days, weeks or months, depending on your analysis.
The concept behind this momentum indicator is that in an upward moving market, the prices usually tend to close next to their high. And during a downward market trend, the prices close next to their low. Transaction signals tend to occur usually when %K crosses successfully through a 3 period MA (moving average), referred to as %D.
The Stochastic Oscillator does not follow volume or price. It basically follows the momentum or speed of price. The momentum keeps changing its direction before the price. Therefore, bearish and bullish divergences in respect to the Stochastic Oscillator can easily be used to predict and forecast reversals. Since it is range bound, it is highly useful for determining oversold and overbought levels.
Commonly Used in Forex Trading
The Stochastic Oscillator is widely used in Forex trading. It is used by traders to gain insights into the potential future of the market direction and make trading decisions accordingly. It attempts to forecast the probability (chances) of the continuation of the existing direction trend. Traders look for signals that are generated by the Stochastic lines.
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- Technical analysis and the Spanish stock exchange: testing the RSI, MACD, momentum and stochastic rules using Spanish market companies – www.tandfonline.com [PDF]