Stochastic oscillators have been used by investors for more than 50 years to predict market momentum and inform investment decisions. We’ve laid out the basics you need to know to start incorporating stochastic oscillators into your strategic playbook.

Stochastic Oscillators in a Nutshell

In securities trading, stochastic oscillators are a momentum indicator intended to help forecast abrupt changes in price by examining the rate at which a security’s price has fluctuated over time. The tool is based on the analytical concept of support and resistance, a stock market analysis that posits that price will reverse once it reaches a certain predetermined threshold. The stochastic, or randomly determined, factor refers to the current closing price of a security in relation to its lowest and highest closing prices over a stipulated time period.

Dr. George Lane realized that price momentum, or the speed at which a security changes price, will reverse direction before an actual price change occurs to disrupt the current trend. With this in mind, he created stochastic oscillators to measure momentum (rather than price or trade volume alone) to serve as a preliminary indicator for buying or selling a security before a market reversal occurs. Today, investors also use stochastic oscillators to determine when to follow strong trends as well as identify divergences.

Identifying Stochastic Trends

On a stochastic oscillator graph, the indicator is measured on the y-axis and can range in value from 0 to 100. The x-axis of a stochastic oscillator tracks time and typically spans 14 periods. If the indicator reading is below 20 at any given time, the price momentum of that security is often interpreted as being oversold. Similarly, readings at the top of stochastic oscillator range (80+) are usually read as being overbought. As a general rule, a security that is overbought is likely to decline, whereas one that is oversold is likely increase—but don’t get too cozy with that rule just yet.

Strong Trends

Overbought and oversold readings don’t always indicate that a security’s price will pivot direction, so it’s important to consider the strength of the trend in addition to the stochastic oscillator value. A security can remain overbought if prices continue to close at an equal or greater value than the previous closing price or what’s known as a strong uptrend. Similarly, a security can remain undersold during a strong downtrend, when prices consistently close at or below the existing bottom range.

Before acting on overbought or oversold readings, weigh stochastic oscillator values against larger market trends and invest in the direction of the wider trend to shoulder the least amount of risk. If the two lines of your stochastic oscillator remain crossed in the same direction during an uptrend or downtrend, it can also be an indication that the trend is still strong and not yet primed for reversal.

Trend Divergences and Reversals

When a price reaches a new extreme (high or low) and that oscillation isn’t mirrored by your stochastic graph, it’s considered a divergence. For example, if the price of a security closes at a record low but the stochastic oscillator reflects that same price drop as a higher low than those previously recorded, it can be an early indicator that the price trend will reverse. If this were true, the most lucrative investment option would be going long. On the contrary, if a price closes at a new high but your stochastic indicator forms a lower high than those previously recorded, it can indicate that the trend is primed for reversal (i.e., that price will decline). In such a case, it would be advantageous to go short.

Once you identify a divergence, be on the lookout for other early confirmation signals that might indicate a trend reversal. Stochastic oscillator signals can take the form of:

• Crossing signal lines or an indicator reading that moves outside the current overbought or oversold range (+20 or −80, respectively)
• A stochastic oscillator reading that traverses the graph’s median (i.e., 50)
• A dip or surge in price that corresponds with a trend reversal

Stochastic Oscillators and Forex

Forex is unique in that every transaction occurs in pairs. On any given forex trade, an investor must simultaneously buy one currency and sell another currency. Stochastic oscillators can be used to help determine on whether to go long or short on a currency in order to reap the greatest potential profit. In the same way that stochastic indicators are used to help predict stock and security trends and reversals, they can be leveraged to better understand price momentum and trends for a single currency.

Conclusion

It’s worth mentioning that not all early signals are accurate, and even the most advanced slow oscillator graphs can produce “whipsaws”—instances when a price that is moving in one direction suddenly pivots without warning and thus produces a false signal. For the most accurate and well-rounded insight, examine stochastic oscillators in conjunction with other analytical models, such as moving averages, and cross-reference your predictions against larger market trends.

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