Trading Course for Beginners: Course 3

Lesson 5: The Stochastic Oscillator: An Introduction (1)

The Stochastic Oscillator: An Introduction

When trading financial markets, it’s important to understand momentum, essentially the rate of acceleration in price action.

The idea is that price momentum often changes ahead of price.

This allows you to gauge the strength of a trend, and forecast a possible reversal.

For example, when a surge in price occurs, we often question whether a bullish trend is emerging, or whether it’s simply a temporary surge that may retrace?

Understanding momentum helps answer these questions.

This is where the Stochastic Oscillator can be helpful.

This indicator provides an easy-to-read directional measurement of current price momentum, bounded between 0 and 100.

It essentially displays two lines, labelled %K and %D.

%K is calculated by taking the difference between the current closing price, and the lowest traded price over the given period. We then divide this value by the difference between the highest and lowest traded price of the same period.

Finally, this value is multiplied by 100.

%K= ((Close - Low)/(High - Low))×100 (“Close minus low, divided by high minus low, times 100”)

%D is just a simple moving average of %K. Usually, the default values for this indicator is 14 periods for %K and 3 periods for %D, though you may adopt different settings depending on your trading style.

This %D value is plotted alongside %K to serve as a signal, or trigger line.

As a simple example of the calculation, let's imagine the close price of an asset is 110, the low for the given period is 90 and the high is 115.

So, 110 minus 90 gives 20. We then find the difference between the high at 115 and the low at 90 to give 25. Dividing 20 by 25 equates to 0.8, and when multiplied by 100 provides us with an 80 stochastic value.

Fortunately, many charting programs compute this calculation for us, though it’s always good to understand the dynamics behind the formula.

What the indicator shows you is where the current price is - compared to where it has been over the given time period, offering you - the trader - an idea of what is happening with price momentum.

A higher number indicates upward momentum, and a lower number shows downward momentum.

The levels most traders pay attention to are 80 and 20, where 80 indicates overbought conditions and 20 represents oversold.

Now we’re familiar with the basics of the Stochastic oscillator, part 2 will go over how and when successful traders use the indicator to engage with markets.

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