Trading BSE Stocks with the Stochastic Oscillator
Developed by George C. Lane in the late 1950s, the Stochastic Oscillator is a momentum indicator that shows the location of the current close relative to the high/low range over a set number of periods.
In this lesson we will show one very accurate stock trading method we like using the Stochastic Oscillator.
First Some History Lane observed that as prices increase in an up trend, closing prices tend to be closer to the upper end of bars and in a down trend closing prices tend to be nearer the lower end of bars. Lane developed stochastics to discern the relationship between the closing price and the high and low of a bar. Typically used to identify overbought and oversold conditions the indicator consists of two lines: % K and %D. |
These two lines fluctuate in a vertical range between 0 and 100. Readings above 80 are considered overbought and readings below 20 are considered oversold.
Calculation
14 is a popular number of periods for calculation:
A 14-day %K (14-period Stochastic Oscillator) would use the most recent close, the highest high over the last 14 days and the lowest low over the last 14 days. The number of periods will vary according to the sensitivity and the type of signals desired.
Slow versus Fast versus Full There are three types of Stochastic Oscillators: Fast, Slow, and Full. The Fast and Full Stochastic is discussed later. For the purposes of this trading method we will only be looking at the Slow Stochastic Oscillator. The driving force behind
all three Stochastic Oscillators is %K (fast), which is found using
the formula provided above. |
Below is a 1 hour chart of the BSE Sensex showing the stochastic settings for this trading method:
Be sure to set the slow stochastic oscillator to K period:15, D period 5 and MA period 5.
Advanced
Look for bullish divergence between price and the stochastic oscillator as shown in the image below:
A 1 hour chart of the BSE Sensex showing divergence and the stochastic oscillator at 14:
Trading Rules (Going Long):
- Identify stochastic divergence, in the image above this is represented by two lines, make sure price is on the move down (green line) and the stochastic oscillator moving up (yellow line) from OVERSOLD conditions (blue arrow).
- Enter the market when price breaks the area of resistance.
- Place your stop below the lowest candle after divergence occured.
- Place a trailing stop of 30 pips or depending on your style of trading you could also draw in Bollinger Band lines and wait for price to retrace to the middle Bollinger Band line as an exit signal.
Conclusion
Readings below 20 are considered oversold and readings above 80 are considered overbought. However, a reading above 80 is not necessarily bearish or a reading below 20 bullish. A security can continue to rise after the Stochastic Oscillator has reached 80 and continue to fall after the Stochastic Oscillator has reached 20.
Some of the best signals occur when the oscillator moved from overbought territory back below 80 and from oversold territory back above 20 but as usual it is best to use the oscillator together with some other indicator as shown above to filter out whipsaws and false signals.
Thank you for joining us in this stock trading method.
The Indiadaytrading Team
 |
Information, charts or examples contained in this lesson are for illustration and educational purposes only. It should not be considered as advice or a recommendation to buy or sell any security or financial instrument.