Stochastic Oscillator

Another popular indicator, the Stochastic Oscillator was invented by Dr. George Lane, and became very popular in the 1990s as it proved very effective. It is quite complicated to calculate, as it compares where the closing price for each day is in comparison to the total price range. As you can imagine, if the closing price is towards the top of the range then it shows that there is buying enthusiasm, and the trend should continue upwards. Here’s the same chart, but with the stochastic oscillator instead of the RSI:

Once again, note that the ups and downs of the indicator tend to reflect the ups and downs of the price chart. Anytime they don’t is usually a “watch out” time. As you can see, the stochastic oscillator has two lines, one of them called %K, and the other dashed line called %D. This is often used as a signal line. In fact there are two types of stochastic oscillator, the fast stochastic which is shown above, and the slow stochastic which averages over more periods and gives a smoother line. There are several variables you can play with to tune this oscillator.
The way this is usually used is to wait until %D is in overextended territory and possibly diverging in direction from the price. The signal to enter a trade is when the %K line crosses over the %D line. Some traders like to use the RSI and the stochastic oscillator together, as the RSI is generally less volatile. If you wait for an extreme condition to occur on both indicators before trading, you are less likely to trade signals that don’t work out.
These are just two of the many oscillators that work in a similar manner. Rather than listing them all, I would encourage you to explore which ones are available on your charting software, pulling them up and seeing how their movement compares with the price action. The general principles are:

  • The time to watch carefully is when the oscillator is at an extreme position, either high or low, as it suggests a price is overextended and may reverse. This can occur during a continuing trend, so you need some other indication before trading on it. The oscillator is only a secondary indicator to follow up on other analysis.
  • If the price and the oscillator are moving in opposite directions, this is a warning that changes may be on the way.
  • When the oscillator crosses the middle line, this can also give a signal. It’s a good idea to only buy long when the oscillator is below the middle, and only take up a short position if the oscillator is above.