The stochastic oscillator
, developed in the 1950s by George Lane, analyzes price movements to gauge the strength and speed of those movements. Lane compared stochastics to a rocket, explaining that "before [a rocket] can turn down, it must slow down. Momentum always changes direction before price".
This belief is rooted in the idea that an asset's closing price typically trades at the higher end of its daily price range in an upwards-trending market, while trading near its daily low during a downturn.
The stochastic oscillator is a momentum-focused indicator prized for its accuracy and clarity. Stochastics gauge an asset's closing price in comparison to a range (measured 0-100) of closing prices over a mutable (though most often 14-day) time period, creating overbought (readings of 80-plus) and oversold (readings of 20 or under) trading signals.
There are two types of momentum with stochastic indicators: 'slow' (indicated in formulas as %K, this is best at gauging wide trading ranges or slower trends) and 'fast' (shown in formulas as %D, this is a moving average of the 'slow' indicator). The crossover of these two values, when graphed, produces transaction signals.Overbought
readings will generally fall into the greater-than-80, less-than-20 range, respectively. Traders should not misinterpret these signals, however, as guarantees of an impending reversal – stronger trends can mean extended stretches of overbought or oversold behavior, making it pertinent for traders to closely examine the behavior of the stochastic oscillator to gain insight into potential shifts.