The Stochastic Oscillator

One of the most popular technical tools is the stochastic oscillator. The Stochastic Oscillator is a momentum indicator that shows the location of the current close relative to the high/low range over a set number of periods.

The theory behind this indicator is that in a bull market, prices tend to close near their high but during a bear market, prices tend to close near their low. What the stochastic indicator is doing is that it's showing us the momentum of the closes within a give time period.
Stochastics move within a scale of 0 to 100. Moves below 20 are considered oversold and moves above 80 are overbought. Here is the formula for a 14 bar stochastic:
C = the most recent closing price
L14 = the low of the 14 previous trading sessions
H14 = the highest price traded during the same 14-day period.

%D = 3-period moving average of %K

Below is a weekly chart of the reit index with the stochastic oscillator in the lower pane. You'll notice that some of the crossover signals were profitable while other signals would have lost money. So as you can see, just taking crossover signals is not going to make you money. What we need is some kind of filter to help give us a higher percentage of winning trades. One of the best ways to do this is to only take stochastic crossover signals in the direction of the trend.

On the chart below I placed a 25 and 50 bar moving average. If the 25 average (blue) is above the 50 average (red) the trend is up and we should only be looking to take stochastic crossover signals when they are oversold (below 20) and then turn back up. If the 25 average is below the 50 average that defines a bearish trend and we should only be looking to sell short when the stochastics are overbought (above 80) and turn back down.

As you can see adding a couple of moving averages as a filter helped us to find more profitable trades and avoid many losing trades. There are other filters you can use such as setting the stochastics to be in tune with the dominant cycle that is present in the market you are trading. For example if there is a 50 bar cycle you might want to use a stochastic setting of 25 which is 1/2 the value of the cycle.
Another filter might be to only take stochastic signals in the direction of the higher timeframe. For example: If you are trading the daily timeframe, you might only want to take buy signals if the weekly stochastic is rising or is above 50.
Another way to use stochastics is to look for divergences but I've found that not to work too well, at least that's my experience.

In my opinion the best way to use the stochastic oscillator is to take signals only in the direction of the trend as shown in the chart below, that seems to work the best for me.

You can scroll through some of my archived posts to see real-time examples of how I've used the stochastic oscillator in my trading. Here are a few links.

Example number one

Example Number Two

Example number three In this example I used %R but stochastics would have showed me the same thing.

Example number four

Example number five