The stochastic oscillator explained simply

The stochastic oscillator goes back to George Lane in the 1950s. It answers a simple question: is the price closing near the top or near the bottom of its range over the last two weeks?

What it's about

The stochastic moves between 0 and 100. You see two lines. The faster one is called %K, the calmer one %D. Above 80 counts as overbought, below 20 as oversold.

An example: over the last 14 days a stock's lowest low was €40 and its highest high €50. Today it closes at €49. So it closes almost at the top of its range, and the stochastic is at 90.

How it's calculated

For %K you take today's close minus the lowest low of the last 14 days and divide that by the whole range, meaning highest high minus lowest low. The result times 100 is the raw value. In the usual slow version, this raw value is smoothed over 3 days. %D is a 3 day average of %K.

With the numbers above: (49 − 40) divided by (50 − 40) gives 0.9, so 90 after multiplying by 100.

What signals traders read from it

• Overbought and oversold: Below 20 some hope for a bounce, above 80 some expect a pullback.
• %K crossing %D: When %K crosses above %D in the low zone, many read it as a buy signal. Crossing below in the high zone as a sell signal.
• Divergence: The price makes a new low, but the stochastic doesn't. That can hint at fading selling pressure.

Where it misleads you

The stochastic reacts quickly, and that's exactly its problem. It often jumps back and forth between the zones and produces lots of signals, many of which lead nowhere. In a strong trend it also stays in extreme territory for a long time. The chart shows this: in the uptrend it sits above 80 for weeks while the price keeps rising.

If you sell every time it's above 80, you get out in exactly the phases where things are going best.

An example trade with made up numbers

Tom has €10,000 in his account and risks at most €150 per trade. On a €30 stock, %K crosses above %D below 20. Tom buys and sets his stop loss at €28.80. With €1.20 of risk per share, he buys 125 shares for €3,750. Costs: €1 each to buy and sell, plus about 2 cents of spread per share on each order.

If it works: The price rises to €32.40. Tom is €300 ahead. After €2 in fees and €5 in spread, €293 is left.

If it goes wrong: The signal came in the middle of a downtrend. The price keeps falling and the stop fills at €28.70. That's a €162.50 loss, €169.50 with costs.

Stochastic buy signals in a downtrend go wrong especially often. That's why many only use it in the direction of the bigger trend.