Stochastic Oscillator

The Stochastic Oscillator is an indicator used in technical analysis of financial markets, developed by Dr. George Lane in the late 1950’s.

It functions as a momentum-based indicator, which aims to determine support and resistance levels by way of oversold and overbought zones.

This indicator also compares to an instrument’s price closed in relation to its price range over a specific period of time.

How to Use the Stochastic Oscillator

The Stochastic Oscillator consists of two lines – the main line, referred to as %K and a second derived line, known as the signal line, and referred to as %D, which is basically a moving average of the first main line.

These two lines, the %K and %D oscillate up and down within a fixed range, from 0 to 100.

Most traders use the default oversold and overbought levels of 20 and 80 respectively, and the most basic use is as follows.

If the Stochastic Oscillator’s two lines are below the 20 level, then the instrument is considered to be oversold and look for possible bullish movement.

By extension, if the two lines are above the 80 level, then the instrument is considered to be overbought, so look for possible bearish movement.

As a result, traders often use the Stochastic Oscillator to predict turning points before they happen. Indeed, the developer of the indicator, Dr. George Lane himself explained, "Stochastics measures the momentum of price.

If you visualize a rocket going up in the air – before it can turn down, it must slow down. Momentum always changes direction before price."

Today the Stochastic Oscillator is a very popular indicator amongst technical traders in virtually all markets, such currency, commodities and stocks.

How to Trade Stochastic Oscillator?

As mentioned above, traders use the indicator to gauge whether the market is oversold or overbought. A popular method to use the Stochastic is to combine four events:

Look for whether the oscillator has exceeded oversold/overbought levels.

Look for a change in direction of both the %K and %D lines.

Look for a crossing of the %K with the %D.

Look for the Oscillator to exit the oversold/overbought zones. As soon as these conditions are met, traders may look to enter the market.