How to Spot Tops and Bottoms

The stochastic oscillator is the very first technical algorithm I learned when I began trading stocks, and I still utilize the stochastic oscillator today. The stochastic oscillator is just one of many commonly used oscillators technical traders use to denote rather a particular security is either overbought (often the top) or oversold (often the bottom).

Background

The stochastic oscillator is a momentum indicator, introduced by George Lane in the 1950s, to compare the closing price of a security to its price range over a set time period. It consists of two indicators that are used in conjunction to predict future prices.

The fast stochastic oscillator or %K calculates the difference between the current closing price and the lowest closing prices in the last N days over the difference between the highest and lowest closing prices in the last N days.

%K = (( Current Closing Price - Lowest N Day Prices ) / ( Highest N Day Prices - Lowest N Day Prices )) * 100

The slow stochastic oscillator or %D calculates the simple moving average of the %K fast stochastic oscillator over M periods.

%D = SMA_M %K

Together these two indicators can be used to determine rather a security should be bought or sold.

Selling

There are two methods that are used to denote when to sell.

1. Sell when the %K line, the blue line, crosses down over the %D line, the red line.
2. Sell when the blue line falls below 80 after rising above 80.

In short, if the oscillator rises above 80 it is good indication that a particular security may be overbought and we should be looking to sell as soon the oscillator comes back down to 80.

Buying

For buying we simply use the opposite strategy. Thus there are also two methods that are used to denote when to buy.

1. Buy when the %K line, the blue line, crosses up over the %D line, the red line.
2. Buy when the blue line rises above 20 after falling below 20.

In short, if the oscillator falls below 20 it is good indication that a particular security may be oversold and we should be looking to buy as soon the oscillator comes back up to 20.

Disclaimer

The stochastic oscillator alone is not enough to denote when to buy or sell a security. In fact it is a hypothetical and statistical algorithm at best, which cannot truly predict human based actions. However, it is one key metric that has accurately predicted buy and sell signals time and time again, but remember it should only be used as a small part of your overall investment strategy. In my personal technical analysis, the stochastic oscillator along with the exponential moving average is one of the first metrics I use to spot tops and bottoms.