Stochastic Oscillator: the complete guide

The idea behind it

Developed by George Lane in the 1950s, the Stochastic starts from an observation: in an uptrend, closes tend to be near the top of the recent range, and in a downtrend near the bottom. The oscillator quantifies that closeness on a scale from 0 to 100.

Formula

%K = 100 × (close − lowest low) / (highest high − lowest low), over 14 periods
%D = 3-period moving average of %K

The raw %K is jumpy, so a “slow” version smooths it once more and is the one most platforms show by default.

Reading the zones and crossovers

Above 80 is called overbought and below 20 oversold: the close is near the extreme of its recent range. As with the RSI, that describes strength of the move, not an automatic reversal. In a strong trend the Stochastic can stay near 80 for a long time.

When %K crosses %D, it signals a change in short-term momentum. Crossovers inside the extreme zones are looked at more closely than those near 50. In a range-bound market the oscillator is most informative; in a trend, many crossovers are noise.

Divergences and mistakes

A divergence appears when the price makes a new extreme but the Stochastic does not. It points to fading momentum, not to a certain turn.

• Treating 80 as “sell” and 20 as “buy”.
• Ignoring the trend: oversold readings in a downtrend can repeat for a long time.
• Changing the settings until the past looks perfect.

Stochastic in InvestAI

InvestAI includes the Stochastic in its set of momentum indicators and explains whether the reading is bullish, neutral or bearish, adapted to the chosen reading horizon.