What is a Stochastic Oscillator?
What is a Stochastic Oscillator
The stochastic oscillator, invented by George C. Lane, is also a very popular overbought-oversold indicator among investors. The stochastic oscillator measures the momentum of price movements, that is, the strength of acceleration. The idea behind the stochastic indicator is that the velocity (momentum) in prices can change before the price movement changes direction.
Stochastics, when used in combination with other technical analysis tools such as moving averages, trend lines, and support and resistance levels, can help determine position entry and exit points more accurately.
Stochastic works by focusing on the position of the closing price of an instrument relative to the price's high and low range over a certain number of historical periods and always fluctuates between the limits of 0 and 100. The underlying assumption of the stochastic oscillator is that in an uptrend, closes reach the upper levels of the price range within a given period; It is the idea that it will be close to the lower regions in case of decreases. The aim here is to try to predict price reversal points by comparing the closing price with price movements over a certain period.
The number of periods used in the stochastic calculation can be optimized, but by default this parameter is between 9 and 14 in most programs. The number of periods here varies depending on the period selected in the chart. For example, on a daily chart this would be 14 days, and on an hourly chart it would be 14 hours.
Usage of Stochastic Oscillator,
The stochastic oscillator compares the current price with the price range within the selected period, reflecting the consistency of the price closing near its recent high or low. While above 80 indicates that the asset in question is overbought; A value below 20 indicates that the market is oversold.
When the stochastic is above 80, %K crossing %D from top to bottom is SELL; When it is below 20, %K crossing %D from bottom to top is used as a BUY signal. This form of implementation is the simplest among stochastic oscillator strategies.
However, in order to benefit from the stochastic oscillator in the most efficient way, it is necessary to know the tips on using the stochastic oscillator. What is important in the Stochastic indicator are the intersections above 80 and below 20. Crossings occurring in other regions should not be taken into consideration as buy-sell signals.
On the other hand, when used with other indicators, apart from the signal given by the oscillator; The direction of the indicator (trend), its current position (where it is) and whether there is a discrepancy with the price also provide separate clues to investors.
Advantages and Disadvantages of Stochastic Oscillator,
The stochastic oscillator is a widely used technical tool among investors, but no technical analysis indicator alone produces successful results without exception. Therefore, when using a stochastic oscillator, it is important to consider this fact and be aware of the advantages and disadvantages of the stochastic oscillator. Some of these are those:
· Advantages
Identifying overbought/oversold areas
It is a very useful and simple indicator to detect overbought and oversold areas, especially in horizontal markets.
Easy to reach
Stochastic oscillator is included in almost all programs with a technical analysis module today.
Mathematical form of calculation
One of the general advantages of indicators and oscillators is that the way they are calculated is based on mathematical precision. Therefore, in this respect, it leaves no room for "what if" questions or "subjective" evaluation.
Can inform about trend reversals
As with many other indicators, the stochastic oscillator can be used to detect and confirm price and indicator divergence trend reversals.
· Disadvantages
Can give wrong signals
When you look at the history of the stochastic oscillator, you can see that it has been wrong many times. This means that trading stochastic alone can lead to losing positions. Therefore, stochastic should be used together with other indicators and it should be examined whether market conditions are suitable for the use of stochastic indicators.
Failure in trending markets
This item can actually be considered a common drawback for all overbought and oversold indicators. Stochastic always takes a value between 0 and 100. This means that, especially in trending markets, the indicator may remain above 80 or below 20 for a long time, producing incorrect buy-sell signals.
Interpretation of Stochastic Oscillator,
The stochastic oscillator chart consists of two lines: One reflects the oscillator value for the current state (%K), the other reflects its simple moving average (%D). The intersection of these two lines is considered a signal that a market reversal could occur, as it indicates a day-to-day change in momentum.
As a technical tool, the stochastic indicator also reveals when an asset price is overbought or oversold. This helps analysts determine the appropriate time and price to buy or sell an asset.
Additionally, the mismatch between the stochastic oscillator and the price movement is interpreted as an important reversal signal. For example, in a downtrend, while new lows are gradually decreasing, the oscillator's lows are rising; This could be an indication that the selling momentum is starting to wear off and the market may turn bullish. (Positive Dissonance)
On the other hand, if the peaks on the asset chart are rising while the peaks on the stochastic oscillator begin to fall, this is a mismatch that indicates that the market may turn from bullish to bearish. (Negative Discord)
How you react when Stochastic enters overbought or oversold areas is closely related to your strategy. If an asset giving an overbought signal reverses, could that reversal be a minor decline, a major correction, or a long-term downtrend? It is difficult to give clear answers to these questions, especially when stochastic is used alone.
That's why the indicator can be combined with other indicators such as RSI, MACD and ADX. For example, with the stochastic signal, it can be checked whether the ADX is below 20 and therefore whether the market is currently trending. If the market trend is weak (ADX below 20), then the stochastic indicator can also be expected to produce better signals. Likewise, along with the buy-sell signal on the stochastic indicator, it should also be checked whether there is a positive or negative mismatch between the price and the indicator.
Finally, when trading with stochastic, the exit point (stop loss) must be determined in advance within the scope of the strategy. When determining a stop level, if the transaction level also coincides with a support or resistance zone, support or resistance can be taken as reference. Apart from this, another method that can be applied to choose the stop loss level is to take the average volatility of the market as a basis by using the indicator called ATR.
Conclusion,
The stochastic oscillator is a useful technical analysis tool in identifying overbought/oversold areas and predicting trend reversals. Its advantages include features such as detection of overbought and oversold areas, easy accessibility, mathematical calculation method and the ability to confirm trend reversals.
However, there is also a risk that the stochastic oscillator may give false signals and may lead to harmful positions, especially when used alone. Therefore, it is important to use the stochastic oscillator in combination with other indicators and observe market conditions.
As a result, it is important to consider all these aspects when using the stochastic oscillator and confirm the signals by using the indicator in conjunction with other technical analysis tools. Additionally, the direction of the indicator, its current position and discrepancies with the price should also be taken into account when interpreting the stochastic oscillator.
