How the Stochastic Oscillator Helps Stock Traders Identify Opportunities

In recent months, we've been examining a range of technical indicators that can be used to detect potential moves in stocks. Used in combination with fundamental and sentimental analysis, technical signals make up an important part of our Expectational Analysis® methodology. This week, I asked Schaeffer's Senior Quantitative Analyst Rocky White to break down one of the lesser-known technical indicators: the Stochastic Oscillator.

What is the Stochastic Oscillator, and when can it be used?

RW: It is an oscillator which is or can be used in nearly any context, but its most obvious use is to find the top and bottom of a stock's range. If a trader is bullish on a stock, he would use it to find an entry point for a long trade (buy it when the indicator is showing the stock is oversold). If a trader is bearish, he could use the Stochastic Oscillator to find an entry for a short position (sell short when indicator shows the stock is overbought).

Also, a trader might use it to find a reversal in a stock by looking at the divergence in the stock price and the indicator. If the stock makes a new low and the Stochastic Oscillator makes a higher low, then it could be a signal for a stock reversal from a downtrend to a new uptrend.

How is the Stochastic Oscillator calculated?

RW: An in-depth explanation of the calculation can be found on this page of our site explaining oscillators, and is generally best done using a computer program. The Stochastic Oscillator is plotted as two lines -- the %K line and the %D line -- with values ranging from zero to 100. Intuitively, the %K figure is where the stock is relative to its high/low over the past 14 days (or whatever time period you choose). If the stock is at the high, then %K is 100. If it’s at its low, then %K is zero. If it the stock is exactly in the middle of those, then %K is 50, etc. The %D is just a moving average of the %K.  

How does with indicator compare with the Relative Strength Index (RSI)?

RW: They are both considered momentum indicators. The main difference I see is that the Stochastic Oscillator is only concerned with the price of the stock compared to its high and low over the past x number of days. The RSI is different in that it does not consider the stock price at all. It looks at actual returns over the past x trading days. Specifically, RSI uses average gains and average losses in its calculation.

Are there times Stochastic is a particularly strong or weak indicator?

RW: The way it is traditionally used, I would say the indicator is best when a stock is in a trading range, or maybe in a well-defined channel when trending up or down. It seems it would be less useful when a known event is about to take place or when a stock or index in general tends to be sensitive to news events.

Can you give an example of when this indicator might be used in a trading decision?

RW: I don’t think this is an indicator that is used a whole lot as a main driver behind a buy/sell decision. However, I did look back since 2016 and found stocks that had a buy signal on the Stochastic. I defined a "buy signal" as the %D line moving from below 20 to above 20, and it had to be the only signal in the last 10 trading days. Then I found the two-week return after the signal. Going back to 2016, the table below shows S&P 500 Index (SPX) stocks that had a 100% win rate after flashing this signal. Leading the group is machinery stock Parker-Hannifin Corp (NYSE:PH), which averaged a 7.6% two-week gain after five prior signals.