The stochastic oscillator belongs to a group of technical indicators known as moment indicators. The underlying philosophy here is that when prices are in an uptrend, the closing price should be near the dayâ€™s highest trading level â€“ reflecting the strong upward momentum in the price. In a bear market the price should close near the dayâ€™s lowest trading level, which will in turn reflect the downward sentiment in the market.
Fig. 10.31(a) below is a typical stochastic oscillator charted for the AUD/USD.
As can be seen from the above chart, the oscillator is made up of two different lines. The %K line (the solid blue line) is basically the raw measure utilized to portray the concept of momentum underlying the oscillator. The formula for calculating %K is:
%K = 100[(C â€“ L5close)/(H5 â€“ L5)]
where C equals the latest closing price, H5 the highest price achieved during the previous 5 periods and L5 the lowest price reached during the same 5 previous trading sessions.
The %D line is generally considered to be more reliable. The formula to calculate its values is:
%D = 100 X (H3/L3)
Usually the stochastic oscillator uses data from the past 14 trading periods (whether that be months, weeks, days, hours or even minutes), but this can be modified to meet the userâ€™s preferences.
The traditional interpretation of the stochastic oscillator is that when the price moves above the 80 level the market has become overbought and itâ€™s time to sell. If it moves below the 20 level the market has become oversold and it is a good time to buy.
In terms of this interpretation points A and B in Fig. 10.31(a) would have been good exit points for existing trades. In both cases this would, however, have left the trader pre-empting the market and missing out on substantial further upward price movements.
An alternative approach is to wait for the two lines to converge. This is shown by points C and D in Fig. 10.31(a) where the %K line has moved into the overbought region and then turned back to cross the %D line.
In both cases using this approach would have given a significantly better result and allowed the trader to cash in on virtually the full market movement.
That the Stochastic Oscillator is not foolproof can clearly be seen from what happened after point E, which indicated a possible price reversal and the beginning of a new uptrend. This did not happen and the price merely started moving sideways.
That is why it is usually a better alternative to get a confirmation signal from a second indicator before venturing into or out of a trade. A popular partner to the stochastic oscillator is the RSI, but for traders who are interested in longer-term trend changes the Japanese Ichimoku Kinko Hyo is also a good alternative.