Stochastic Oscillator is a point of reference that compares the difference or deviation of the recent closing price with lowest and highest point over a particular period. The oscillator reacts to change in market movements by applying a standard average of the result or by altering a time frame.
Here are the primary uses of the stochastic oscillator:
1. Divergence
Divergence can occur after the security price experiences a new low or high and is not indicated on the Stochastic Oscillator. Prices can move to a new low, but there is no corresponding change on the oscillator to reflect the new low reading.
Often, this divergence can signal an imminent market reversal to indicate a movement from a downward trend to an upward trend. However, you have to keep in mind that the oscillator might also offer a divergence signal before the price actions reflect a change in direction.
2. Identify oversold and overbought levels
Any stochastic reading that is above 80 is used to indicate an overbought level. On the other hand, readings below 20 reflect oversold conditions. When the oscillator leaps above 80 and then shoots downwards to levels below 80, it automatically indicates the right moment to sell.
Subsequently, if the indicator moves below 20 and then shoots upward above 20, then this is the best time to sell. Oversold and overbought levels simply indicate the position of the security price in the market and can either be near the bottom or at the top.
3. Crossovers
Crossovers refer to a point in time when the slow stochastic line and the fast-stochastic line intersect. The fast stochastic line is indicated by the 0%K line while the slow stochastic line is depicted by the %D line. A buy signal occurs when the %K line crosses above the %D line. On the other hand, a sell signal generates when the %K line crosses below the %D line.
While the Stochastic Oscillator is a popular momentum indicator, it can also generate false signals. Therefore, you should use it with other technical indicators, instead of using it as the only source of trading signals.
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