Stochastic Oscillator

The Stochastic Oscillator is yet another momentum indicator that tries to predict trend reversals by identifying overbought and oversold conditions. While its moving average-based calculations are rather complex, the simple thing to understand is that this indicator consists of two lines: the indicator itself, and a signal line.

The values of the Stochastic Oscillator range from 0 to 100. When the indicator line crosses the signal line, a trend reversal may be close. When the reading of the oscillator is over 80, it is an indication that the market has entered overbought territory and a reversal in price direction may be near. A short trade could be entered when the value of the Stochastic Oscillator is back down below 80. Similarly, a reading below 20 indicates market being oversold. Once we see that the price climbs enough for the Stochastic Oscillator to display a reading above 20, we may enter a long trade.

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As with all other indicators, I encourage you to not trust one indicator alone. It is always recommended to seek confirmation of a reversal by other means. One of the most popular ways to confirm a reversal in connection with the Stochastic Oscillator, is to keep an eye on the volume levels. If during the same period of time when this oscillator is entering the overbought/oversold zone above 80 or below 20 the volumes start to decrease, it may be an indication of market exhaustion. Overbought/oversold conditions coupled with market exhaustion are a pretty clear signal that the probability for a reversal is increasing.

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