Given the hundreds of indicators that are available to traders, finding the appropriate technical tools to use in day trading can be a difficult task. The good news is that the majority of indicators can be used in day trading simply by adjusting the number of time periods used in creating the indicator.
Most traders are accustomed to seeing each indicator use each daily close as one period in the calculation, but they quickly forget that the interpretation remains the same whether the data used in one period is equal to a day, a minute, a week, a month, or a quarter.
One indicator chosen by many traders is the stochastic oscillator, which we discuss below.
Key Takeaways
- In day trading, traders use technical analysis to find indicators to help with trading decisions.
- One common indicator is the stochastic oscillator, which is used to determine overbought and oversold signals.
- The stochastic oscillator compares an asset's closing price to a range of its prices over a certain period.
- The stochastic oscillator can be either fast or slow, with the slow stochastic being popular as it reduces the chance of entering a position based on a false signal.
The Stochastic Oscillator
The stochastic oscillator is a momentum indicator. It analyzes an asset's closing price at a specific time to a range of its prices over a specific period of time. The goal of the indicator is to determine overbought or oversold signals so that a trader knows when to buy or sell. The range of values for the stochastic oscillator is 0-100.
The stochastic oscillator is calculated using the following formula:
%K=(H14−L14)100∗(CP−L14)where:C=MostrecentclosingpriceL14=Lowofthe14previoustradingsessionsH14=Highestpricetradedduringthesame14-dayperiod
A %K result of 80 is interpreted to mean that the price of the security closed above 80% of all prior closing prices that have occurred over the past 14 periods. The main assumption is that a security's price will trade at the top of the range in a major uptrend.
A three-period moving average of the %K called %D is usually included to act as a signal line. Transaction signals are usually made when the %K crosses through the %D.
Using the Stochastic Oscillator
Generally, a period of 14 days is used in the above calculation, but this period is often modified by traders to make this indicator more or less sensitive to movements in the price of the underlying asset.
In an upward-trending market, prices should close near the highs, while in a downward trend, they should close near the low end.
Fast vs. Slow
The "speed" of a stochastic oscillator refers to the settings used for the %D and %K inputs. The result obtained from applying the formula above is known as the fast stochastic. Some traders find that this indicator is too responsive to price changes, which ultimately leads to being taken out of positions prematurely.
To solve this problem, the slow stochastic was invented by applying a three-period moving average to the %K of the fast calculation.
- Fast: the formula is shown above, but using a 3-period moving average (MA) of %K.
- Slow: replace %K with the Fast D% (i.e. the MA of %K); replace D% with a MA of slow K%.
Taking a three-period moving average of the fast stochastic's %K has proved to be an effective way to increase the quality of transaction signals; it also reduces the number of false crossovers.
After the first moving average is applied to the fast stochastic's %K, an additional three-period moving average is then applied—making what is known as the slow stochastic's %D. Close inspection will reveal that the %K of the slow stochastic is the same as the %D (signal line) on the fast stochastic.
Why Use the Slow Stochastic
The slow stochastic is one of the most popular indicators used by day traders because it reduces the chance of entering a position based on a false signal. You can think of a fast stochastic as a speedboat; it is agile and can easily change directions based on sudden movement in the market. A slow stochastic, on the other hand, is more like an aircraft carrier, in that it takes more input to change direction.
In general, a slow stochastic measures the relative position of the latest closing price to the high and low over the past 14 periods. When using this indicator, the main assumption is that the price of an asset will trade near the top of the range in an uptrend and near the bottom in a downtrend.
This indicator is very effective when used by day traders, but one problem that may arise is that some charting services might not include it as an option on their charts. If this is the case for you, you may want to consider re-evaluating which charting service you use.
Is RSI or Stochastic Better?
Determining which technical indicator is better, the relative strength index (RSI) or stochastic oscillator will depend on the trading goals. RSI is better suited for long-term trading while the stochastic oscillator is better used for short-term trading.
Can You Use RSI and Stochastic Together?
Yes, both indicators can be used together on the same chart. Generally, in technical analysis, it is recommended that traders use more than one indicator. RSI and stochastic oscillator are both momentum indicators that can provide additional insight when used together rather than if they were both used individually.
What Does %K and %D Mean in Stochastic?
In stochastic oscillators, %K is a line that shows an asset's lowest price and highest price in a specific time frame to create a price range. It shows the last closing price as a percent of this range. The %D line exists from %K in that it is a moving average of %K.
The Bottom Line
Day traders use technical analysis indicators to assist with trading decisions. The stochastic oscillator helps determine overbought and oversold assets but as with most indicators, it should not be used alone but alongside other indicators to paint a broader picture of an asset's true investment profile.
The comments, opinions, and analyses expressed on Investopedia are for informational purposes online. Read ourwarranty and liabilitydisclaimerfor more info.
