A stochastic oscillator remains one of the most popular and powerful technical analysis tools for trading and almost all trading platforms include one. This chart shows an asset’s closing price against a simple moving average over a three day period and is used to predict likely price changes in the near future.
The stochastic indicator is a valuable tool in all markets but is particularly popular in forex markets.Many traders find good use for this analytic tool and as long as you understand stochastic oscillator pros and cons, it can help you to make informed decisions on market entry and exit.
What is a stochastic oscillator?
Developed in the 1950’s by Dr George Lane, it shows the momentum of price changes rather than the actual price. It tends to turn before the price so it serves as a useful leading indicator of price direction.
The stochastic indicator is a chart that represents the closing price of an asset relative to its highs and lows over time. The trader chooses the length of time. The most common period is fourteen days. A smaller number of periods will react more quickly to price changes but it may also generate unreliable signals. A higher number of periods will offer more reliable information but it will react slowly to price changes.
A stochastic oscillator operates on the premise that the closing price of an asset is a good indicator of the direction that the price will take. So, if an asset closes near the top of a candlestick, it is likely to rise and if it closes near the bottom it will decline.
This technical tool indicates the momentum of a security or trade by measuring the closing price against price movements over a set period. The oscillator is range-bound between 0 and 100. Readings of over 80 are considered in the range of overbought stocks and less than 20 as oversold. These positions appear as solid lines on the chart.
How a Stochastic Oscillator work
A stochastic oscillator measures momentum rather than price movement ranges.
Stochastic oscillators consist of two lines, the %K and the %D. %K indicates the real value for each session. The other line, %D shows the simple moving average of %K over three days. An intersection of the lines will often indicate a likely change in the direction of the price. Since the momentum of the change has accelerated.
The danger of these charts is that the readings may not necessarily indicate a reversal. Financial assets often remain in an overbought or oversold position for a considerable period. Traders must look out for changes in the trends before making the decision to buy or sell. It is best to use these tools in conjunction with other available tools like candlestick charts and moving averages.
That said, stochastic indicators are great in ranging markets. In such conditions when the stochastic reading is less than 20 and the %K crosses the %D upwards traders using the indicator will buy. When the stochastic reading is over 80 and the %K crosses the %D downwards, traders will sell.
The Pros and cons of stochastic indicators
To get the most out of stochastic indicators, traders must understand where they excel and where they fail.
- Depending on the period chosen, you should receive frequent signals
- It offers clear market entry and exit signals
- It is simple to use
- Most charting packages have stochastic indicators so they are easily accessible
- It can produce false signals especially in volatile markets
- Assets can remain in overbought or oversold positions for a very long time and unless the you have been watching the trends over time it is possible to lose money on a mistimed entry or exit.
Traders will find stochastic oscillators helpful if they understand the charting shortfalls and make allowances. It is important, however, that you don’t trade blindly or you could lose money.
Trading is all about building up investments for the future. Realistic expectations and careful use of available tools like the stochastic oscillator could help you to early retirement.