Stochastic Oscillator

By mosesbet · Filed Under Spread Betting Comments Off on Stochastic Oscillator 

The Stochastic Oscillator is another fairly simple indicator which identifies whether a market is overbought or oversold based on its price range over time.  The Stochastic was propagated by Dr Charles Lane in the 1950s and is momentum indicator which offers support and resistance levels.

The Stochastic Oscillator works by studying the current price of a market relative to its price range over time.  It looks at whether the market is overbought or oversold not by following the price or volume but rather by studying “the speed or momentum of change”.

The formula for the Stocashtic Oscillator is below (you don’t really need to understand how it works):

Essentially, the Stochastic compares the closing price to the price range and attempts to predict turning points or reversal in the price (similar to the Parabolic SAR).  Prices tend to close at the extremes of the price range just before a reversal.

How to Use the Stochastic Oscillator

The Stochastic uses a range of 1-100 for its price range.  When the Stochastic lines are above 80% (the red horizontal line) than it means the market is overbought and should drop in price.  In other words we could use this as out resistance level and place a limit above it.

If the Stochastic line falls below 20% (the blue horizontal line) then it means the market is oversold and should bounce up again.  You should place an order to go long when the Stochastic line falls below 20% since this indicates the price is well below its price range and should reverse upwards again.

A Stochastic Pop occurs when the prices break out and keep going.  In this situation you should either hold onto your position or liquidate quickly if the market’s going against your position.

The problem with the Stochastic Oscillator is that since it is a momentum indicator it obviously fails to take into account future break-outs at the support and resistance levels. Unlike the Fibonacci Extension Levels for example which predict future price movements and dynamic support and resistance levels, the Stochastic Oscillator is only really used to “anticipating” reversals.  Thus, the Stochastic Oscillator is much more similar to the Parabolic SAR then anything else.

 

 

 

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