Simply put, a stochastic indicator a.k.a. stochastic oscillator refers to and reads the momentum of assets that may refer to an upward or downward movement. And then, use this data in order to determine the point at which the momentum shifts because the price can go no higher or no lower.
A common misconception about this indicator is that it measures price plus date plus volume. This is because these concepts are relevant to the oscillator. To be more accurate however, these concepts are only a means to an end or rather a means to measure momentum. This article will proceed to discuss other key concepts to elucidate the reader.
Fast vs. Slow vs. Full
Going by SharpCharts there are three versions of a stochastic indicator. First is the fast stochastic oscillator that appears as “choppy” and used to emphasize signals. Second is the slow stochastic oscillator that appears as “smooth” or is less pronounced. Third is the customizable full stochastic oscillator that allows one to look further back into historical data.
Overbought vs. Oversold
A stochastic indicator has a range of 0 to 100. An overbought situation occurs when the demand increases to a point where in the price is driven so high that the buyer can no longer keep up. This results in a slowdown and eventual drop in price. An oversold situation occurs wherein the demand is low hence the price drops. When the price drops to a certain degree interest on the asset is rekindled hence the demand will increase. The significance of the discussion is that via an oscillator a person is able to monitor the upwards and downwards trend. One school of thought says this will result in the ability to predict a shift in prices before it occurs. Another school of thought says this allows a person to see the reversal as soon as it happens. In any case action is taken upon reversal.
Positive vs. Negative Divergence
Stochastic indicators or oscillators make use of divergence as a signal. Positive divergence occurs when the oscillator goes up but the underlying asset or security goes down. As a general rule positive divergence occurs when the selling strength is slowing down or weakening. Negative divergence occurs when the oscillator goes down but the underlying asset or security goes up. This usually indicates a weakening buying strength.
The Role of Technology
Simply put a trader must utilize any and all means in order to get raw data, indicators, analysis as close to real time as possible. This is achievable thru fast internet connectivity, smart devices, alerts, live feeds, etc. Of course the reliability of the source must also be established.
A Stochastic indicator is a very useful tool. However it is not the only tool. A trader can be an expert in oscillators and still mess things up. In order to minimize this from occurring one has to cross-reference oscillators with other indicators, charts, analysis, newsfeeds, etc. Simply put you need as much information as you can get before buying, selling, or staying put.