The Stochastic Oscillator, developed by George Lane, measures where the current closing price sits relative to its high-low range over a set lookback period. The underlying idea is that in an uptrend, prices tend to close near the top of their recent range, and in a downtrend near the bottom.
The Formula
%K = (Close - LowestLow_n) / (HighestHigh_n - LowestLow_n) x 100The %D line is typically a 3-period simple moving average of %K, smoothing it into a signal line. Standard settings are 14 periods for %K and 3 for %D, though shorter settings such as 5,3,3 are common for faster signals.
Overbought and Oversold Zones
- ▸Above 80: the market is considered overbought — the close has been near the top of its range.
- ▸Below 20: the market is considered oversold — the close has been near the bottom of its range.
- ▸In a strong trend, the oscillator can stay in extreme territory for extended periods — overbought does not automatically mean 'sell'.
Crossover Signals
A common signal is a %K/%D crossover within the extreme zones: when %K crosses above %D below the 20 line, it can suggest a bullish turn from oversold conditions; when %K crosses below %D above the 80 line, it can suggest a bearish turn from overbought conditions.
Stochastic Divergence
As with other oscillators, divergence between price and the stochastic can signal weakening momentum. If price makes a higher high but the oscillator makes a lower high, upward momentum may be fading even though price is still rising.
Stochastic works best in ranging conditions where price oscillates between clear boundaries. In a strong trend it can flash repeated overbought or oversold signals while price keeps moving in the trend direction, leading to premature exits or counter-trend losses.
Filter stochastic signals with the broader trend: only take bullish crossovers from oversold in an uptrend, and bearish crossovers from overbought in a downtrend. This aligns the oscillator with the dominant market direction.