Popularized by legendary futures trader George Lane, the stochastic oscillator (commonly called stochastics) is a timing indicator widely used by futures traders to indicate overbought or oversold positions. Stochastics compares closing price to price range over a specified time period. The driving principle can be summarized as follows:
- In an uptrend, as prices rise, the closing price rises to the top of the recent price range.
- In a downtrend, as prices fall, the closing price drops to the bottom of the recent price range.
In charting, the stochastic oscillator uses two lines to give a single signal. The major line (%K) is usually depicted as a solid line. The second line (%D) is often depicted as a dotted line and represents a 3-day moving average of %K. Futures traders watch the %D line closely for major trading signals. When %D crosses %K, the intersection of the two lines indicate buy/sell points. Use the following rule of thumb to read stochastics signals:
- When both the %K and %D lines are below 20 and the faster %K line crosses above the slower %D line, BUY.
- When both lines are above 80 and the %K line crosses under the %D line, SELL.
The two lines rise and fall in tandem between 0 and 100. Readings above 80 are overbought; those below 20 are oversold. Savvy futures traders will watch for divergences which can indicate coming price trends over the next few time periods.
Futures traders value stochastics for its accurate findings. Easily understood, even by novice traders, stochastics provide valuable indicators for making good entry and exit decisions.
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