The Stochastic Oscillator looks at the relationship of a stock's current price to its highest close and its lowest close and the average of these during the measurement period. Like the RSI, Dr. Lane recommended a 14 period measurement.
According to Dr. Lane's theory, stocks that are in an upward trend will close near the high of the day. Stocks that are in a downward trend will close near the low of the day. Stocks with a Stochastic reading above 80 are considered overbought, and stocks that trade below 20 are considered oversold.
The indicator consists of two measurements, a fast reaction momentum line (a 3 period simple moving average) designated K% and a slow reaction momentum line (a 14 period simple moving average) designated D%. D% is the moving average of K%. It is the D% line that gives the 80%/20% overbought and oversold signals.
The Stochastic Oscillator gives signals at least three ways.
- The overbought/oversold signals discussed above are the first signal.
- A second signal is a crossover signal. You would buy when the K% line crosses above the D% line and sell when the reverse happens. This can produce too many trades so other indicators should be used to confirm this signal to avoid having transaction costs absorb all of your profits. The preferred signal is when the K% line crosses above after the peak of the D% line (think of D% looking like a mountain with the K% crossing just after the top of the mountain). Because this happens to the right of the peak, it is called a "Right-Hand Crossover".
- The third signal is a divergence signal. A positive divergence is when the D% line moves above 20 and the stock price is declining. The second move above 20 after a positive divergence would confirm the signal to buy. The second dip below 80 after a negative divergence (the D% line is moving down and the stock price is rising), would signal a sell.
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