Stochastic Oscillator

Stochastic Oscillator is one of the famous momentum indicator. Momentum indicator is used to measure the rate of change of the stock price. The theory behind momentum indicator is simple. It implies that price will go up/down forever continuously. It need to rest for a while especially after strong  movement in one direction. So when we see the sign of a stock want to rest, we sell it. When we see a stock start getting momentum, we buy it. It is very simple.

Stochastic Oscillator usually consists of 2 lines (sometimes 3 lines).

%K(14days) =  (Current Close- Lowest Low in past 14days)/(Highest High in past14days- Lowest Low in past 14days)*100

%D = 3days SMA of %K

(Third Line = Smoothed %D)

As we can see from formula %K, stochastic oscillator measures the location of current close price among the range of highest price and lowest price in past 14days. If current price is the highest among past 14days, %K= 100.

There are 2 simple method in using stochastic oscillator

1 Monitoring the trend

During an uptrend, if the lowest point of %D becomes higher and higher, it means the trend become stronger. If the movement of %D is only above center line (50%) and does not fall below it, it means the stock is in super strong uptrend. It is similar for the situation in downtrend.

2 Short term buy/sell call

Stochastic Oscillator is a sensitive indicator that can be used to  earn short term profit from the retract and rebound of the stock price. In an uptrend, when %D  that was always above 80% upper limit start to break the limit line, it means a short term sell call and the stock price want to have a rest since above 80% upper limit is a high tension area. When %D falls touching 20% and rebound, it is a short term buy call and means the stock price has enough rest and start to move again.

However, since stochastic oscillator is very sensitive and sometimes give a false selling signal especially when %D oscillate around  80% upper limit. There are two suggestions to solve this problem. First, Refer stochastic oscillator together with another momentum oscillator: RSI. When stochastic oscillator falls below 80% together with RSI falls below 70%, sell out the stock. Second, Wait 2-3days after %D leaves 80% upper limit, if there is a sign of rebound, keep it. If there is no rebound, sell it.

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