The Stochastic Oscillator is classed as a momentum indicator and was developed by Dr. George Lane. The indicator compares the closing price of the security in relation to the price range over a number of set periods.

The formula below defines the calculation for the Stochastic Oscillator.

%K = 100[(C – Ln)/(Hn- Ln)]

C = Current Closing Price

Ln = Low over the period n

Hn = High over the period n

%K will be multiplied by 100 so the decimal place is moved two places to the left.

The default setting for the Stochastic Oscillator is 14 periods and is generally days but can be any time frame. A daily 14 period %K would use the latest close and the high and low over the last 14 days.

The formula below is used in conjunction with %K.

%D = 3-period moving average of %K

This signifies a 3 day moving average of the %K and is generally drawn alongside the %K and acts as a possible transaction signal.

The Stochastic Oscillator is range bound between 0 and 100 and uses settings of 80 and 20 to indicate overbought and oversold conditions respectively. You should bear in mind a reading that is consistently over 80 may just indicate a strong uptrend and does not always mean a possibility of bearish behaviour ahead. Likewise a reading that is consistently below 20 may indicate strong bearish behaviour, not that bullish price action is about to occur.

The following chart of the EUR/USD shows the Stochastic Oscillator with its default settings.

Like the RSI divergences occur when when new highs and lows are created and the value of the Stochastic Oscillator fails to proceed higher or lower respectively.

As seen in the following chart of the EUR/USD bullish divergences occur when price makes a lower low and the Stochastic Oscillator makes a higher low.

This can be a possible sign of changing momentum and could be proceeded by a bullish reversal pattern. A bearish divergence is the opposite and forms when price forms a higher high and the Stochastic Oscillator forms a lower high. Again this is an indication of changing momentum and possible bearish reversal pattern.