Stochastic oscillator

The stochastic oscillator is a momentum indicator that compares a stock's most recent closing price to the range it has traded in over a set lookback period, used to gauge whether the stock is overbought or oversold. The underlying idea is that during a strong uptrend, prices tend to close near the top of their recent range, and during a strong downtrend, they tend to close near the bottom, so measuring where the close sits within that range can reveal shifts in momentum.

The indicator produces two lines, plotted on a scale of 0 to 100. The faster line, called %K, measures the current close relative to the high and low of the lookback period, commonly 14 sessions. The slower line, %D, is a moving average of %K, smoothing it out to reduce noise. Readings above 80 are generally considered overbought, and readings below 20 are generally considered oversold, similar in spirit to the relative strength index, though the two indicators are calculated differently and can sometimes disagree.

The formula is:

Traders commonly watch for %K crossing above or below %D as a trade signal, similar to a moving average crossover, and also look for divergence between the stochastic oscillator and price, where the stock makes a new high or low that the oscillator fails to confirm. Because it is sensitive to short term price swings, the stochastic oscillator tends to generate more frequent signals than slower momentum tools, which makes it popular with short term traders but also more prone to false signals in choppy, range-bound markets.