Overbought or Oversold Stocks: Stochastic Oscillators Can Help Time Trades

Overbought or Oversold Stocks: Stochastic Oscillators Can Help Time Trades

Key Takeaways

    The stochastic oscillator, created in the 1950s, is designed to signal support and resistance levels

    It attempts to track price momentum and signal when a stock price may have gotten ahead of itself, or “overbought” vs. “oversold” stocks

    Stochastics can be combined with other technical indicators to help determine trends

“It doesn’t follow price, it doesn’t follow volume or anything like that. It follows the speed or the momentum of price. As a rule, the momentum changes direction before price. If you visualize a rocket going up in the air—before it can turn down, it must slow down. Momentum changes direction before price.”

These are the words Dr. George Lane used to describe the stochastic oscillator, one of the most regularly followed trend indicators. Lane, a Chicago futures trader and early proponent of technical analysis, developed the momentum indicator in the late 1950s. Not clear on stochastics, or how to interpret “overbought” or “oversold” stocks? You’re not alone. Even some veteran traders have a hard time understanding the mechanics behind this technical indicator. So let’s break it down and look at how stochastics can be incorporated into your trading.  

Long and Short of the Stochastic Oscillator

The stochastic oscillator measures the distance between a stock’s closing price and its range of highs and lows over a specified period. As the stock closes near the high of the range, the stochastic oscillator rises, and as the stock closes near the low of the range, it falls. Proponents like the stochastic oscillator because of its easy-to-remember range of zero to 100, its support and resistance indications, and its ability to help signal divergences in share movement. According to Dr. Lane, the stochastic oscillator moves into overbought and oversold areas above 80 or below 20, respectively.

The default calculations are based on a relatively simple formula, one that might look at home in a 10th grade math book. It’s plotted with two lines, the %K line and the %D signal line, defined as follows:

    %K = (Current close – lowest low)/(highest high – lowest low) * 100%D = 3-day simple moving average (SMA) of %KLowest low = Lowest low for the user-defined look-back periodHighest high = Highest high for the user-defined look-back period

There are three main stochastic oscillators: slow, fast, and full. The difference between the fast and slow versions is simple: one is more sensitive than the other. Think of the fast stochastic oscillator as a speedboat, able to change directions quickly amid rapidly changing conditions, while the slow stochastic oscillator is more like a yacht, taking more time to change course. The full stochastic oscillator is a version of the slow stochastic oscillator that can be fully customized by the user.

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How to Use the Stochastic Oscillator

Some traders say that stochastics, because of its sensitivity, can be a good indicator to use when a stock is trading in a range, but when a stock is in a strong trend, a stochastic chart can often show inconsistent and false signals. With that in mind, it might help to use stochastics alongside other technical indicators to help determine overbought and oversold stock conditions.

As with most oscillators, you’ll first need to know the directional trend of the stock: rising or falling. And you’ll need to determine that trend over a set time, for example, a 20-period simple moving average (SMA), as shown in figure 1. A move above the 20-day SMA shows a potential bullish entry signal. Conversely, a potential exit presents itself when the stock closes below the 20-day SMA.

Overbought or Oversold Stocks: Stochastic Oscillators Can Help Time Trades

FIGURE 1: ENTRY/EXIT SIGNALS, OVERBOUGHT/OVERSOLD CONDITIONS. The stochastic oscillator can show where a stock may have gotten ahead of itself—to the upside as well as the downside. In this example, after an “oversold” condition, the %K crosses over the %D to the upside (a potential signal of positive momentum), roughly concurrent with a price close above the 20-day SMA (a potentially bullish signal). A week later, the opposite occurred: “overbought” conditions, a cross of the %K below the %D, and a close below the 20-day SMA. Image source: the TD Ameritrade thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

The slow stochastic oscillator can sometimes be used to signal the beginning of a trend change when combined with other technical triggers. For example, if the indicator crosses up from below the 20 level at the same time that a reversal pattern occurs on a candlestick chart, it may be a strong sign that the trend is changing. Figure 1 shows an example.

Whether slow, fast, or full, stochastic oscillators each have their own individual traits that can be exploited to your benefit. But the overbought/oversold indicator may require a bit of testing and experimenting with the values to best fit your style of trading.

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