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The stochastic oscillator was developed in the late 1950s by George Lane. As designed by Lane, the stochastic oscillator presents the location of the closing price of a stock in relation to the high and low range of the price of a stock over a period of time, typically a 14-day period. Lane, over the course of numerous interviews, has said that the stochastic oscillator does not follow price or volume or anything similar. He indicates that the oscillator follows the speed or momentum of price.

Lane also reveals in interviews that, as a rule, the momentum or speed of the price of a stock changes before the price changes itself.2ο»Ώ In this way, the stochastic oscillator can be used to foreshadow reversals when the indicator reveals bullish or bearish divergences. This signal is the first, and arguably the most important, trading signal Lane identified.

Example of How to Use the Stochastic Oscillator

The stochastic oscillator is included in most charting tools and can be easily employed in practice. The standard time period used 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. As a hypothetical 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 the current price to the range over time, the stochastic oscillator reflects the consistency with which the price closes near its recent high or low. A reading of 80 would indicate that the asset is on the verge of being overbought.

The Difference Between The Relative Strength Index (RSI) and The Stochastic Oscillator

The relative strength index (RSI) and stochastic oscillator are both price momentum oscillators that are widely used in technical analysis. While often used in tandem, they each have different underlying theories and methods. The stochastic oscillator is predicated on the assumption that closing prices should close near the same direction as the current trend.

Meanwhile, the RSI tracks overbought and oversold levels by measuring the velocity of price movements. In other words, the RSI was designed to measure the speed of price movements, while the stochastic oscillator formula works best in consistent trading ranges.

In general, the RSI is more useful during trending markets, and stochastics more so in sideways or choppy markets.

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