Developed by George C. Lane in the 1950s, the stochastic oscillator is one of a handful of momentum metrics used by analysts and traders to predict potential reversals. Instead of measuring price or volume, the stochastic oscillator compares the most recent closing price to the range for a given period. The standard period is 14 days, though this can be adjusted to meet specific analytical needs. The stochastic oscillator is calculated by subtracting the low for the period from the current closing price, dividing by the total range for the period, and multiplying by 100. For example, if the 14-day high is 150, the low is 125, and the current close is 145, then the reading for the current session would be (145-125)/(150-125)*100, or 80. By comparing current price to the range over time, the stochastic oscillator reflects the consistency with which price closes near its recent high or low.
The stochastic oscillator is range-bound, meaning it is always between 0 and 100. This makes it a useful indicator of overbought and oversold conditions. Traditionally, readings over 80 are considered in the overbought range, and readings under 20 are considered oversold. However, these are not always indicative of impending reversal; very strong trends can maintain overbought or oversold conditions for an extended period. Instead, traders should look to changes in the stochastic oscillator for clues about future trend shifts.
Stochastic oscillator charting generally consists of two lines: one reflecting the actual value of the oscillator for each session, and one reflecting its three-day simple moving average. Because price is thought to follow momentum, the intersection of these two lines is considered to be a signal that a reversal may be in the works, as it indicates a large shift in momentum from day to day.
Divergence between the stochastic oscillator and trending price action is also seen as an important reversal signal. For example, when a bearish trend reaches a new lower low but the oscillator prints a higher low, it may be an indicator that bears are exhausting their momentum and a bullish reversal is brewing.