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What is The Stochastic Oscillator?

Welcome to the Investors Trading Academy talking glossary of financial terms and events. Our word of the day is “Stochastic”. The Stochastic Oscillator is a technical indicator that moves back and forth between 0 and 100, providing a gauge of stock momentum. Developed by George C. Lane in the 1950s the main uses for the Stochastic Oscillator include divergences which can foreshadow reversals, overbought/oversold readings, bull/bear trade setups and crossovers which help pinpoint trade entries. The indicator shows how the current price compares to the highest and lowest price over the look back period. Typically the look back is 14 periods; on a weekly chart that is 14 weeks, on an hourly chart 14 hours. When the indicator is near zero it shows the price is trading near or below the lowest low during the look back period. If the indicator is near 100, the price is trading near or above the highest high during the look back period. Above 50 and the price is trading within the upper portion of the 14 period range; below 50 and the price is trading in the lower portion of the 14 period range. An asset is overbought when the Stochastic is above 80, and is oversold if the indicator is below 20. The labels are misleading though; overbought doesn’t necessarily mean the price will drop immediately, and oversold doesn’t mean the price will rally immediately. Overbought and oversold simply mean the price is trading near the top or bottom of the 14 day range, respectively. These conditions can last for a long time. Traders do use overbought and oversold levels to monitor reversals though. If the indicator is overbought -above 80 and then falls below 50, it indicates the price is moving lower. If the price was oversold -below 20 and rallies above 50 it indicates the price is moving higher. By Barry Norman, Investors Trading Academy