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Stochastic oscillator explained

Updated: Apr 9, 2023

A stochastic oscillator, also known as Stochastics, is a popular technical analysis indicator used by traders to measure momentum in the price of an asset. The indicator was developed by George Lane in the 1950s, and it is based on the idea that prices tend to close near the highs of an uptrend and near the lows of a downtrend.

The Stochastic oscillator consists of two lines, %K and %D, that are plotted on a chart with a range of 0 to 100. The %K line is the main line, and it is calculated using the following formula:

%K = (Current close - Lowest low) / (Highest high - Lowest low) x 100

The %D line is a moving average of the %K line, and it is typically calculated over a period of three to five days. The %D line is used to smooth out the fluctuations in the %K line and make it easier to interpret.

The Stochastic oscillator is used to identify overbought and oversold conditions in the price of an asset. When the %K line crosses above the %D line and both lines are below 20, it is considered an oversold condition, and a buy signal may be generated. When the %K line crosses below the %D line and both lines are above 80, it is considered an overbought condition, and a sell signal may be generated.

Traders also use the Stochastic oscillator to identify bullish and bearish divergences between the price of an asset and its Stochastic values. A bullish divergence occurs when the price of an asset is making lower lows, but the Stochastic oscillator is making higher lows. This can be a sign that a bullish reversal may occur. A bearish divergence occurs when the price of an asset is making higher highs, but the Stochastic oscillator is making lower highs. This can be a sign that a bearish reversal may occur.

Overall, the Stochastic oscillator is a versatile technical analysis tool that can be used to identify potential buy and sell signals, as well as overbought and oversold conditions and divergences in the price of an asset.



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