Overbought and oversold conditions mean that the security price is near the top of its trading range and potentially overbought or near the bottom and possibly oversold in any specified period. These overextended levels enable savvy traders to buy or sell the trading ranges. Stochastics don’t have to reach extreme levels to evoke reliable signals, especially when the price pattern shows natural barriers. While the most profound turns are expected at overbought or oversold levels, crosses within the center of the panel can be trusted as long as notable support or resistance levels line up. Moving averages, gaps, trendlines or Fibonacci retracements will often intercede, shortening a cycle’s duration and flipping power to the other side. This highlights the importance of reading the price pattern at the same time you interpret the indicator.
The stochastic oscillator is especially useful among commonly day-traded assets such as low float stocks that have limited amounts of shares and are more volatile. Chart 5 shows Autozone (AZO) with a support break in May 2009 that started a downtrend. With a downtrend in force, the Full Stochastic Oscillator (10,3,3) was used to identify overbought readings to foreshadow a potential reversal. The shorter look-back period (10 versus 14) increases the sensitivity of the oscillator for more overbought readings. For reference, the Full Stochastic Oscillator (20,5,5) is also shown.
How Do You Make Stochastic Charts With Excel?
Similarly, a bullish divergence at a major support level could generate a strong buy signal. However, crossovers should be used in conjunction with other technical analysis tools or price action to confirm the signals and reduce the likelihood of false positives. Usually, it is a 3-period simple moving average, but the length can vary based on the analyst’s preference. It calculates the distance of the current closing price as it relates to the median of the high/low range of price. William Blau developed the SMI, which attempts to provide a more reliable indicator, less subject to false swings. The Stochastic Momentum Index (SMI) is a more refined version of the stochastic oscillator, employing a wider range of values and having a higher sensitivity to closing prices.
Bullish and bearish divergences in the stochastic oscillator can signal potential trend reversals. A bullish divergence occurs when the price forms a lower low, but the stochastic oscillator forms a higher low. This tool is primarily used by technical analysts to gauge the momentum of assets. The stochastic oscillator stochastic oscillator definition is a technical indicator of momentum used to compare the closing price to a range of prices over a given period of time. This oscillator is sensitive to fluctuations in market price, although the level of fluctuation in the indicator can be smoothed somewhat by altering the time period being measured.
On the indicator, price is “overbought” when the two lines are above the upper horizontal line. Conversely, the price is “oversold” once the two moving lines break below the lower line. This indicator works to help you identify market trends by presenting two lines that move or “oscillate” within a horizontal range.
For instance, in the EURUSD chart below, the overall trend is up, which means traders should only look for buy entry signals at oversold levels if you believe in Dow Theory. Chart patterns or price formations work well with stochastic oscillators to give you better trades. Trendlines are great for use when trading stochastic divergence and reversal trades. Find an established trend with a valid trendline, and then wait until the price breaks the trendline when the stochastic indicator lines make a new high or low. You should note that the stochastic indicator may offer a divergence signal a while before price action changes direction. The stochastic momentum index (SMI) is based on the stochastic oscillator, and both tools are used to determine momentum in the market.
Stochastic Oscillator Formula
Below is the calculation for a standard 14-period stochastic indicator but the time period can be adjusted for any time frame. While the Stochastic Oscillator is best suited for trading ranges, it can also be used with securities that trend, as long as the trend has a zigzag format. In an uptrend, pullbacks are parts of the zigzag that move higher. A suitable adjustment of the oscillator’s sensitivity may be needed for these scenarios. George Lane identified another form of divergence to predict bottoms or tops, dubbed “set-ups.” A bull set-up is basically the inverse of a bullish divergence.
- Therefore, it is best used along with other technical indicators, rather than as a standalone source of trading signals.
- The Stochastic Momentum Index (SMI) is a more refined version of the stochastic oscillator, employing a wider range of values and having a higher sensitivity to closing prices.
- The stochastic reading for a possible overbought market condition occurs when it’s above 80.
- It is advisable to use this strategy in conjunction with other indicators or price action confirmation.
- Its primary incentive is to understand how strong the market’s momentum is.
American Airlines Group (AAL) rallied above the 50-day EMA after a volatile decline and settled at new support (1), forcing the indicator to turn higher before reaching the oversold level. It broke out above a 2-month trendline and pulled back (2), triggering a bullish crossover at the midpoint of the panel. https://www.bigshotrading.info/ The subsequent rally reversed at 44, yielding a pullback that finds support at the 50-day EMA (3), triggering a third bullish turn above the oversold line. However, the stochastic momentum index (SMI) shows the closing momentum relative to the median high or low range for a particular time period.