How the Stochastic Oscillator is Calculated
The stochastic oscillator is calculated using a three-day rolling average of the percentage difference between the closing price and the closing price n-periods ago. The closing price is used as the latest data point in the calculation. The first step is to calculate the percentage difference between the closing price and the closing price (n) periods ago, where n is the number of periods used to calculate the stochastic oscillator. For example, if the closing price of a stock is $100 and the previous closing price is $95, the percentage difference is $100 - $95 = $5, so the percentage difference is 5%. The next step is to divide the percentage difference by the percentage difference n periods ago, where n is the number of periods used to calculate the stochastic oscillator. In the previous example, the closing price is $100 and the previous closing price is $95. The percentage difference between these two closing prices is ($100 - $95) / $95 = 5/95 = 0.05. This means that 0.05/0.05 = 1, so the percentage difference is unchanged from n periods ago. The final step is to add this number to the closing price. The closing price is $100 and 0.05 is added to this price, resulting in a new closing price of $100 + 0.05 = $100.05. This is the new closing price used in the next period when calculating the percentage difference between the closing price and the closing price n periods ago.
Reading the Stochastic Oscillator
The stochastic oscillator is plotted on a chart as a line graph, with the closing price representing the y-axis and the period used to calculate the oscillator representing the x-axis. Traders can then use the stochastic oscillator to identify potential trend changes, overbought and oversold conditions, and potential trade entry and exit points.
When the closing price is above the 20-period moving average, this indicates that the current trend is strong and could potentially continue in the same direction. Traders use this information by plotting the oscillator line above the 0 lines to identify potential bullish trade entries and downtrend reversals, respectively. When the closing price is below the 20-period moving average, this indicates that the current trend is weak and could potentially change direction. Traders use this information by plotting the oscillator line below the 0 lines to identify potential bearish trade entries and uptrend reversals, respectively.
When the closing price is above the 80-period moving average, this indicates that the current trend is strong and could potentially continue in the same direction. Traders use this information by plotting the oscillator line above the 0 lines to identify potential bullish trade entries and downtrend reversals, respectively. When the closing price is below the 20-period moving average, this indicates that the current trend is weak and could potentially change direction. Traders use this information by plotting the oscillator line below the 0 lines to identify potential bearish trade entries and uptrend reversals, respectively.
Types of Trading Signals from the Stochastic Oscillator
The stochastic oscillator typically generates three trading signals: a buy signal, a sell signal, or a sell-buy signal. A buy signal is generated when the closing price is above the 20-period moving average, the oscillator line is above the 0 lines, and the oscillator line is rising. A sell signal is generated when the closing price is below the 20-period moving average, the oscillator line is below the 0 lines, and the oscillator line is falling. A sell-buy signal is generated when the closing price is above the 20-period moving average, the oscillator line is above the 0 lines, and the oscillator line is falling.
False Signals from the Stochastic Oscillator
The stochastic oscillator is known to generate false trading signals, meaning that the oscillator may signal a trading signal that does not occur. The false trading signals generated by the stochastic oscillator are usually a result of incorrect interpretation of the indicator's signals. Traders can reduce the number of false trading signals generated by the stochastic oscillator by interpreting its signals correctly. The oscillator generates false trading signals when the closing price is above the 20-period moving average, the oscillator line is above the 0 lines, and the oscillator line is falling. Traders could incorrectly interpret this signal as a buy signal when it is a sell signal.
Using the Stochastic Oscillator in Combination with Other Indicators
Due to the nature of the stochastic oscillator, it is best to use it in combination with other indicators to help reduce the number of false trading signals generated by the oscillator. Traders can use indicators like the MACD or moving average convergence-divergence to confirm that the closing price is above the 20-period moving average. Traders can also use indicators like the RSI or the relative strength index to confirm that the oscillator line is above the 0 lines. Combining the stochastic oscillator with other indicators helps traders confirm that the oscillator is generating a valid signal and that the trend will likely change direction. Combining multiple indicators also allows traders to confirm that the oscillator is generating a valid signal by looking at the different signals generated by each indicator.
