Stochastic Oscillator is one of the commonly used indicators by many traders to measure the exit and entry. However, there isn’t 1 indicator that fits all trends. If you like to use Stochastic Oscillator but are still confused about why it sometimes works but sometimes doesn’t, we will share with you the in-depth of this indicator, starting from the origin of its formula structure in this blog.
Stochastic Oscillator Formula:
Understanding how the formula works is important. This will let us know the data that's been used for the calculation of its lines and what are the results of this calculation for.
The formula of the Stochastic Oscillator is to calculate the %K line which is also known as the Fast Stochastic Line. Where the %D is derived from the 3 period MA of %K. Therefore, the main focus here is %K.
%K formula consists of the current closing price, the lowest price traded in the past 14 trading days, and the highest price traded in the past 14 trading days. This shows that the result of this formula is to find the traded price falls in which range of the High & low of the trading days.
This means that the %K is an indication to tell us how fast the price is changing within the 14 periods of the trading day, while the High & Low of the past 14 days have not changed much.
To make it easier for you to understand the formula structure, we have illustrated the below image by breaking down the formula structure for your understanding:
Based on the above illustration, %K basically measures the recent price change within the last 14 days high and low. Usually, the Highest price & Lowest price don’t change often unless it is in a trending situation (up/ downtrend), setting a new high or low daily. The recent closing price is the variable that could have huge changes within the 14 days. When the recent price changes are close to the previous 14 days high, %K would probably be around 80% or more.
By understanding this, we know that the %K is a measurement of how fast the price changes within the given period. This means %K is just an indication that tells us, the recent price changes are near the range of the previous 14 days' High & Low changes.
Can we apply %K & %D overbought oversold as an indication for exit or entry?
The answer is no because %K & %D served as an alert to us that the recent price change is near to the H14 & L14 changes range. If the big boys still have the intention to push higher, then a new H14 will be formed. OR dumping their shares to a lower price, a new H14 will be formed. That’s why you will notice that %K will often stay at the oversold zone (below 20%) when it is in a downtrend.
How do we apply a Stochastic Oscillator to gauge our entry & exit?
George Lane the developer of Stochastic Oscillator once said in an interview:
“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…”
This means the first thing we need to look at is whether there is a short term bullish or bearish divergence in %K & %D with the price. But many traders or “Gurus” nowadays share the wrong steps or ideas, focusing only on the overbought & oversold indication.
Therefore, to analyze the stock price changes or trend reversal, we need to look at it with the steps below :
1) Any divergence in price & %K line
2) Then act upon it when the %K line is overbought or oversold after the Divergence is formed.
- Do not use divergence as the final indication of the short term price reversal. Short term price reversal might come later after a divergence is shown. Therefore, treat any sign of divergence as a pre-alert to a price reversal.
- Big boys sometimes will continue to mark up the price to distribute the remaining shares in their hands to maximize the profit, before dumping the remaining small percentage of their holding out to the market and creating a sharp price fall.
- If your input is 14 days then the measurement will only be 14 days before the recent price. The highest & lowest traded price 28 days before might be different from the recent 14 days. When you are studying the indicators for any divergence, make sure the data are in-line with the time the divergence is formed.
- Because the formula records data of traded high & low prices, therefore, in an up-trending or down-trending stock, the High & Low of the traded price will continue to change. Which will cause more variables/ changes in the formula and not be able to define a constant range of High & Low for the %K to measure overbought or oversold. That’s why Stochastic is better for sideways trending stocks.
Limitation of Stochastic
The limitation of the Stochastic Oscillator is the same as many other indicators, lagging & price reacted before stochastic actually shows the signal. Which might cause the traders or investors late to exit and not able to maximize the potential profit while potential losses might incur.
These flaws are very common in many indicators, it is because the indications are based on historical price changes. The developers are trying to smoothen the price movement by averaging out the price data and assuming the price will be traded in the same pattern. As we know in the current financial market, prices don't move in the same pattern with all the available trading functions in the market such as short selling, market size, & expectation of the big boys.
When price & volume are being averaged out, the information from the price & volume transacted pattern are being ignored or taken out. That’s why indicators are not able to tell the intention of the big boys whether they are attracting buyers with price marked up & false buy transactions, or preparing to dump the shares out to the retail investors parking at the lower buy order.
If you really want to use indicators for your trades or investments, you must study and understand how your indicators work in different trends, market size, volatility, & other factors that could affect the indicator’s formula having too many variables.
OR you can spend the same amount of time to understand your indicators on understanding how big boy's work by analyzing the price & volume. Which is the basis & the core of all indicators.
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