WallStreet.io contributor and analyst. Author of upcoming book on market volatility.
Trading With Indicators: Stochastic Oscillator
Every successful stock trader is continually on the hunt for the elusive “edge”, a piece to the trading puzzle that contains a high probability of generating a steady profit by predicting a stock’s future price with a reasonably high degree of accuracy. *
That edge may be in the form of a historically reliable trading strategy (though strategies may degenerate as markets and trading patterns evolve,) or a series of tools that provide replicable outcomes over extended time periods.
So how does one find such an edge? Ah, that’s literally the million dollar question.
Well, many of the most successful stock traders pinpoint reliable trading strategies that provide a high degree of consistent, positive returns. While that’s obviously easier said than done, it remains a “gettable” outcome, one that’s certainly worthy of pursuit.
For stock traders that consider accurate data as the holy grail for trading success, a superior trading strategy frequently lies in choosing historically sound technical indicators that provide superior trade opportunities by predicting a stock’s future price with a demonstrable degree of profitable performance.
So what exactly is a technical indicator? It may be defined as a mathematical calculation that utilizes a stock’s historic data for either price or volume. Put in context, a technical indicator is a tool used in the process of technical analysis for predicting the change in a specific traded asset’s price pattern or trend.
Some popular technical indicators with solid track records include Bollinger Bands, Relative Strength Index (RSI), Moving Average Convergence Divergence (MACD), and Stochastic Oscillator.
To kick off Wall Street IO’s Trading with Indicators series, we’ll start with the Stochastic Oscillator, which falls into the category of momentum indicators.
In case you’re wondering, a momentum indicator is defined as a lagging indicator that measures the rate of the rise or fall in stock prices. Another way to put it is this; a momentum indicator compares a specific closing price of a stock, derivative or other security, to a range of its prices over a specific time frame.
In other words, it’s a tool that indicates the strength or weakness in a stock’s price.
So what is a Stochastic Oscillator?
So what exactly is a Stochastic Oscillator and most importantly, how can it help you make profitable trades?
Let’s start with a brief glance at its origins, which takes us back to the 1950’s. That’s when George Lane developed the Stochastic Oscillator during a period when he was a member of a futures traders group in Chicago.
Lane emphasized that the Stochastic Oscillator doesn’t track price or volume, but rather the speed or momentum of price.
So now it’s 60 years later and the Stochastic Oscillator has survived the test of time, and to this day remains a core indicator for thousands of technical analysts.
OK, so how does it work exactly?
If you want to get a little wonky about it, the Stochastic Oscillator is based on the theory that when a specific market trends upward, then the result is that prices will close near that market’s high. Conversely, a downward trending market will see prices settle close to its low.
The actual transaction signals, or the indication of when to make the move in or out of the trade, are generated when the %K crosses through a three period moving average, which is designated by the %D.
The official geek formula looks like this:
Put in simpler terms, the Stochastic Oscillator provides the location of a stock’s closing price in relation to both its high and low price range over a set time period. The most frequently used time frame is 14 days.
An Accurate Buy and Sell Indicator?
So how can a Stochastic Oscillator be used to generate profitable trades? Here’s the deal:
If the indicator is adjusted correctly, it can generate overbought and oversold trading signals, and is range-bound between 0-100. The most widely used readings are 80 and 20, with the former indicating that a market is overbought and the latter indicating that it is oversold.
It would be a mistake, however, to assume that those readings are absolute trading signals. Rather, it is better to view the readings as a potential sign of future trend shifts. One reason for that suggestion is that if the market is in an extremely strong trend, it can maintain either overbought or oversold conditions for longer periods than might at first be assumed based solely on the initial Stochastic reading.
If you take a look at the Stochastic Oscillator for any given stock (which can be easily pulled up on any Wall Street IO stock chart,) you will see that it consists of a pair of lines. The first reflects the actual value of the oscillator for the day’s session, while the second reflects that stock’s three-day moving average.
It is generally accepted that price follows momentum, and therefore the intersection of the two discrete lines is regarded as a signal of a potential reversal, and therefore a sign of a looming large momentum shift.
In other words, a properly calibrated Stochastic Oscillator can help show traders when the best time to get in on a trade is, and conversely, when it’s the smart time to get out.
Like many widely used trading indicators, the Stochastic Oscillator works well in tandem with others, such as The Relative Strength Index (RSI), which we’ll cover in one of the upcoming Trading with Indicators posts.
So how do I apply the Stochastic Oscillator to my trading strategies?
When you go to the WallStreet IO platform, you can pull up almost any stock and quickly click on an indicator of choice. If you click on Stochastic, you’ll get to the indicator’s pictograph stock chart.
The default settings are not guaranteed to yield the best possible results. You may choose to backtest settings instantly with the WallStreet.io One Click Backtest tool or find verified strategies, utilizing the Stochastic Oscillator indicator, found by the Wallstreet.io Super Processor in the Cloud.
In other words, you can tweek the indicator, backtest it, and see if it generates results superior to the default setting. You don’t even have to be a geek to do it, either!
There are seemingly a limitless number of trading indicators, as well as trading strategies, available to the intrepid traitor, and sorting out the most valuable ones can be a daunting task.
But fortunately, not an impossible one.
As virtually every successful trader has acknowledged, education is the key to becoming a profitable trader.
That jibes with Wallstreet.io’s mission, which is to provide cutting edge trading education along with its world-class suite of trading tools.
A full-on online trading University? Yes, it’s right there for your benefit, with content for both beginners and advanced traders. Check it out at Wallstreet.io.