stochastic oscillator definition – What is a stochastic

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Stochastic Oscillator Definition

What Is A Stochastic Oscillator?

A stochastic oscillator is a momentum indicator comparing a particular closing price of a security to a range of its prices over a certain period of time. The sensitivity of the oscillator to market movements is reducible by adjusting that time period or by taking a moving average of the result. It is used to generate overbought and oversold trading signals, utilizing a 0-100 bounded range of values.

Key Takeaways

  • A stochastic oscillator is a popular technical indicator for generating overbought and oversold signals.
  • It was developed in the 1950s and is still in wide use to this day.
  • Stochastic oscillators are sensitive to momentum rather than absolute price.

The Formula For The Stochastic Oscillator Is

%K = ( C − L14 H14 − L14 ) × 1 0 0 where: C = The most recent closing price L14 = The lowest price traded of the 14 previous trading sessions H14 = The highest price traded during the same 14-day period %K = The current value of the stochastic indicator \begin &\text<\%K>=\left(\frac <\text– \text> <\text– \text>\right)\times100\\ &\textbf\\ &\text\\ &\text\\ &\text\\ &\text\\ &\text<14-day period>\\ &\text<\%K = The current value of the stochastic indicator>\\ \end ​ %K = ( H14 − L14 C − L14 ​ ) × 1 0 0 where: C = The most recent closing price L14 = The lowest price traded of the 14 previous trading sessions H14 = The highest price traded during the same 14-day period %K = The current value of the stochastic indicator ​

%K is referred to sometimes as the slow stochastic indicator. The “fast” stochastic indicator is taken as %D = 3-period moving average of %K.

The general theory serving as the foundation for this indicator is that in a market trending upward, prices will close near the high, and in a market trending downward, prices close near the low. Transaction signals are created when the %K crosses through a three-period moving average, which is called the %D.

Stochastic Oscillator

What Does The Stochastic Oscillator Tell You?

The stochastic oscillator is range-bound, meaning it is always between 0 and 100. This makes it a useful indicator of overbought and oversold conditions. Traditionally, readings over 80 are considered in the overbought range, and readings under 20 are considered oversold. However, these are not always indicative of impending reversal; very strong trends can maintain overbought or oversold conditions for an extended period. Instead, traders should look to changes in the stochastic oscillator for clues about future trend shifts.

Stochastic oscillator charting generally consists of two lines: one reflecting the actual value of the oscillator for each session, 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 from day to day.

Divergence between the stochastic oscillator and trending price action is also seen as an important reversal signal. For example, when a bearish trend reaches a new lower low, but the oscillator prints a higher low, it may be an indicator that bears are exhausting their momentum and a bullish reversal is brewing.

The stochastic oscillator was developed in the late 1950s by George Lane. As designed by Lane, the stochastic oscillator presents the location of the closing price of a stock in relation to the high and low range of the price of a stock over a period of time, typically a 14-day period. Lane, over the course of numerous interviews, has said that the stochastic oscillator does not follow price or volume or anything similar. He indicates that the oscillator follows the speed or momentum of price. Lane also reveals in interviews that, as a rule, the momentum or speed of the price of a stock changes before the price changes itself. In this way, the stochastic oscillator can be used to foreshadow reversals when the indicator reveals bullish or bearish divergences. This signal is the first, and arguably the most important, trading signal Lane identified.

Example Of How To Use The Stochastic Oscillator

The stochastic oscillator is included in most charting tools and can be easily employed in practice. The standard time period used is 14 days, though this can be adjusted to meet specific analytical needs. The stochastic oscillator is calculated by subtracting the low for the period from the current closing price, dividing by the total range for the period and multiplying by 100. As a hypothetical example, if the 14-day high is $150, the low is $125 and the current close is $145, then the reading for the current session would be: (145-125)/(150-125)*100, or 80.

By comparing current price to the range over time, the stochastic oscillator reflects the consistency with which price closes near its recent high or low. A reading of 80 would indicate that the asset is on the verge of being overbought.

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The Difference Between The Relative Strength Index (RSI) and The Stochastic Oscillator

The relative strength index (RSI) and stochastic oscillator are both price momentum oscillators that are widely used in technical analysis. While often used in tandem, they each have different underlying theories and methods. The stochastic oscillator is predicated on the assumption that closing prices should close near the same direction as the current trend. Meanwhile, the RSI tracks overbought and oversold levels by measuring the velocity of price movements. In other words, the RSI was designed to measure the speed of price movements, while the stochastic oscillator formula works best in consistent trading ranges.

In general, the RSI is more useful during trending markets, and stochastics more so in sideways or choppy markets.

Limitations Of The Stochastic Oscillator

The primary limitation of the stochastic oscillator is that it has been known to produce false signals. This is when a trading signal is generated by the indicator, yet the price does not actually follow through, which can end up as a losing trade. During volatile market conditions this can happen quite regularly. One way to help with this is to take the price trend as a filter, where signals are only taken if they are in the same direction as the trend.

Stochastic RSI -StochRSI Definition

What Is the Stochastic RSI?

The Stochastic RSI (StochRSI) is an indicator used in technical analysis that ranges between zero and one (or zero and 100 on some charting platforms) and is created by applying the Stochastic oscillator formula to a set of relative strength index (RSI) values rather than to standard price data. Using RSI values within the Stochastic formula gives traders an idea of whether the current RSI value is overbought or oversold.

The StochRSI oscillator was developed to take advantage of both momentum indicators in order to create a more sensitive indicator that is attuned to a specific security’s historical performance rather than a generalized analysis of price change.

Key Takeaways

  • A StochRSI reading above 0.8 is considered overbought, while a reading below 0.2 is considered oversold. On the zero to 100 scale, above 80 is overbought, and below 20 is oversold.
  • Overbought doesn’t necessarily mean the price will reverse lower, just like oversold doesn’t mean the price will reverse higher. Rather the overbought and oversold conditions simply alert traders that the RSI is near the extremes of its recent readings.
  • A reading of zero means the RSI is at its lowest level in 14 periods (or whatever lookback period is chosen). A reading of 1 (or 100) means the RSI is at the highest level in the last 14 periods.
  • Other StochRSI values show where the RSI is relative to a high or low.

The Formulas For the Stochastic RSI (StochRSI) are:

RSI = Current RSI reading;

Lowest RSI = Lowest RSI reading over last 14 periods (or chosen lookback period); and

Highest RSI = Highest RSI reading over last 14 period (or lookback period).

How to Calculate the Stochastic RSI

The StochRSI is based on RSI readings. The RSI has an input value, typically 14, which tells the indicator how many periods of data it is using in its calculation. These RSI levels are then used in the StochRSI formula.

  1. Record RSI levels for 14 periods.
  2. On the 14th period, note the current RSI reading, the highest RSI reading, and lowest RSI reading. It is now possible to fill in all the formula variables for StochRSI.
  3. On the 15th period, note the current RSI reading, highest RSI reading, and lowest reading, but only for the last 14 period (not the last 15). Compute the new StochRSI.
  4. As each period ends compute the new StochRSI value, only using the last 14 RSI values.

What Does the Stochastic RSI Tell You?

The StochRSI was developed by Tushar S. Chande and Stanley Kroll and detailed in their book “The New Technical Trader,” first published in 1994. While technical indicators already existed to show overbought and oversold levels, the two developed StochRSI to improve sensitivity and generate a greater number of signals than traditional indicators could do.

The StochRSI deems something to be oversold when the value drops below 0.20, meaning the RSI value is trading at the lower end of its predefined range, and that the short-term direction of the underlying security may be nearing a low a possible move higher. Conversely, a reading above 0.80 suggests the RSI may be reaching extreme highs and could be used to signal a pullback in the underlying security.

Along with identifying overbought/oversold conditions, the StochRSI can be used to identify short-term trends by looking at it in the context of an oscillator with a centerline at 0.50. When the StochRSI is above 0.50, the security may be seen as trending higher and vice versa when it’s below 0.50.

The StochRSI should also be used in conjunction with other technical indicators or chart patterns to maximize effectiveness, especially given the high number of signals that it generates.

In addition, non-momentum oscillators like the accumulation distribution line may be particularly helpful because they don’t overlap in terms of functionality and provide insights from a different perspective.

The Difference Between the Stochastic RSI and the Relative Strength Index (RSI)

They seem similar, but the StochRSI relies on a different formula from what generates RSI values. RSI is a derivative of price. Meanwhile, stochRSI is derivative of RSI itself, or a second derivative of price. One of the key differences is how quickly the indicators move. StochRSI moves very quickly from overbought to oversold, or vice versa, while the RSI is a much slower moving indicator. One isn’t better than the other, StochRSI just moves more (and more quickly) than the RSI.

Limitations of Using the Stochastic RSI

One downside to using the StochRSI is that it tends to be quite volatile, rapidly moving from high to low. Smoothing the StochRSI may help in this regard. Some traders will take a moving average of the StochRSI to reduce the volatility and make the indicator more useful. For example, a 10-day simple moving average of the StochRSI can produce an indicator that’s much smoother and more stable. Most charting platforms allow for applying one type of indicator to another without any personal calculations required.

Also, the StochRSI is the second derivative of price. In other words, its output is two steps away from the actual price of the asset being analyzed, which means at times it may be out of sync with an asset’s market price in real time.

Stochastic Oscillator

06 April, 2020, 05:40 AM IST
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Definition of ‘Stochastic Oscillator’

Definition: Stochastic Oscillator is one of the important tools used for technical analysis in securities trading. This technique was developed in late 1950s by Dr. George Lane. The indicator picks one observation point in current base and refers to all points in the defined range from where the highest and lowest point are considered for comparison. It helps to decide the current momentum when compared to high & low of historic set in form of support and resistance levels. For this the consideration point is price of the security in a term defined but it never follows the price pattern as it tracks the momentum or oscillation in the price movement. Dr. Lane stated the fact of rule “the momentum changes before the price moves to that direction” on the basis of which this tool was developed.

Description: Stochastic compares the deviation or difference of current point with highest and lowest point in a specified period and the formula used is explained below:

%K = 100*((C – L(N)) / (H(N) – L(N))

%K is the derived indicator value

C is the current price point

L is the lowest price point over a specified period

H is the highest price point over a specified period

N is the defined period which can 5, 10, 14, 21 etc normally 14 is widely used period

By using this formula we can calculate different points of %K for a period of time in historic data set by dividing the data in different clusters e.g. 14 which can days, weeks, months etc. These points are then plotted on a graph as line chart. The %K value describes the level of current price in the look back high-low range considered, if its near 0% then that is termed as near bottom level and if it’s near 100% that is termed as near highest level. This indicator results can be quite abrupt due to its sensitivity to market movements, which can be minimized by averaging the price points. This means by taking moving average whether simple, exponential or weighted etc. which is 3-day moving average as explained below:

%D is 3 day moving average of %K values

Usually a simple moving average is considered for above calculation. Average values derived are then plotted on graph along with %K line where we study the divergence between %D and %K of the security in question. Now evolved concept has been introduced in the study of stochastic oscillator which is Fast Stochastic Oscillator and Slow Stochastic Oscillator where Fast one is calculation of %K & %D and slow one is 3-day simple moving average of %D

This theory explains that current price will follow the price trend, if it’s on upward direction. Price will close near that or vice versa but stochastic will show the momentum or trend reversals in advance when %K crosses through 3-day %D or %D-Slow from bottom or top. The main points of stochastic oscillator are:

a) Calculation of %K where

– time periods – which the user can define, mostly used period is 14

– data set price, volume, returns where required points are current value, highest & lowest value in one time period

b) Calculation of %D where

– time period – which 3 day

– moving average of %K values

Take a default period 14-day for calculation %K

– In the first cluster, take price values of last 14 days excluding the current. From the cluster then pick highest price and lowest price points now calculate by using formula e.g. current price is 7950.50, highest value is 8055.00 and lowest is 7691.20 so

%K = 100*((7950.50-7691.20) / (8055.00-7691.20)) = 71.27 which shows it’s towards higher range

Likewise %K values are calculated for every cluster

Now calculate %D which 3-Day simple moving average of %K

– In the first cluster take first three %K values e.g.

%D = (72+71.27+70.73)/3 = 71.33

Similarly %D values are calculated for whole set

Source – Technical charting tool

At, there are technical analysis tools to calculate simple stochastic oscillator but also stochastic momentum index where fast & slow oscillation can be defined and different averaging methods can be used for calculation of %D.

These are some of important points highlighted how to interpret Stochastic Oscillator, there are two lines plotted on graph along with price line 1) %K and 2) %D

· These lines generally shows bullish/bearish crossover, strength of upward/downward divergence or over bought/sold scenarios

· When %K or % D falls near 0% then it’s a buy signal or when it is near 100% then sell at those levels as it shows overbought and oversold situations

· When %K line rises above the %D line then buy and when it falls below the %D line then sell

· Divergence is simply gap between %K and %D lines

· Bullish market is seen where prices are constantly touching new highs and on same time the Stochastic Oscillator is not able to breach its previous highs and gap is greater that’s a upward divergence

· Where gap decreases or two lines come closer that shows downward divergence

· When the %K line intersects %D line that shows a crossover

· When %K line crosses above the %D line, the security is gaining at a fast momentum than the average which is represented by the %D line and it’s a buy signal

· A sell signal is seen when %K line is crossing under the %D line which shows security market is declining

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