One of our favorite technical indicators is the Stochastic oscillator – generally used as an overbought/oversold indicator. I am not going to bore you with the details of the formula because it is rather complex and there are various parameters whose values can be changed to affect the eventual results. It seems that everyone has their own idea of how best to use the Stochastic oscillator – and I am no exception.

The Stochastic oscillator(s) I prefer to use have been customized and tuned for short term trading. I use my version because it works for me – but it was not designed by the hand of God – there are probably other good ways to skin this cat, but I prefer my version for my particular purposes.

My Stochastic oscillator system consists of three separate Stochastic calculations and plotted as three individual lines. The three lines are:

1. The red line is a Fast %K Stochastic oscillator calculated over seven bars.

2. The green line is a Slow %K Stochastic oscillator calculated over 28 bars.

3. The blue line is a Slow %K Stochastic oscillator calculated over 84 bars.

We do not plot the %D nor its signal line in our system.

The only other lines plotted are the horizontal lines representing the 20, 50 and 80 values of the oscillators.

Our Stochastic oscillator system is shown in Figure 1.

Figure 1

The Stochastic oscillator moves from a maximum of 100 to a minimum of 0.The 100 value (rarely achieved by the slower lines) represents an extremely overbought condition. Converse, the value of 0 (rarely achieved by the slower lines) represents an extremely oversold condition.

The major problem with the Stochastic (and all other similar indicators) is that they can stay overbought or oversold for an extremely long period of time in cases of a very strong trend. However, in a non-trending market (market moving sideways) they can produce excellent buy and sell signals.

It is easy to see from the above chart that the better trades would be when all three Stochastic oscillators are near an extreme value.

The Cyan dots are alerts generated from the Stochastic oscillator system – and some, but not all, lead to very good trade entry points.

Used carefully, as we do in TBL, the Stochastic oscillator can be a valuable technical indicator – not alone, but as a key component of a balanced system.