The Stochastic Oscillator is a momentum indicator showing the current close in relation to the high/low range over a set number of periods. Closes at or near the top of the range represent accumulation days, while closes at or near the bottom of the range represent distribution.
How is it calculated?
%K = 100[(C - L14)/(H14 - L14)] C = the most recent closing price
L14 = the low of the 14 previous trading sessions
H14 = the highest price traded during the same 14-day period.
%D = 3-period moving average of %K
Readings below 20 are considered oversold conditions and readings over 80 are considered overbought conditions. Some believe that you should sell when the stochastic gets above 80 because it may represent a top and buy when the stochastic reads below 20 because it could represent a bottom. I myself look at these readings to get a “feel” for the stock, but usually do not make trades based purely on these readings. Some traders also buy into a position when the %K line crosses above the %D line and sell when the %K line crosses below the %D line. Again I do not trade based on these signals because these crossover signals are quite frequent and can result in the trader getting whipsawed. One of the most reliable signals is to wait for divergence to develop from overbought or oversold levels:
1) When the oscillator reaches overbought levels, readings above 80, wait for a negative divergence to develop and then cross below 80.
2) When the oscillator reaches oversold levels, readings below 20, wait for a positive divergence to develop and then cross above 20.
Here we have an example of a negative divergence (Sell Signal)
Here is an example of a positive divergence (Buy Signal)
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