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The stochastic oscillator is a momentum indicator comparing the closing price of a stock to the range of its prices over a certain period of time. The general theory serving as the foundation for this indicator is that in a market trending upward, prices will close near the high, and in a market trending downward, prices close near the low.
Stochastic oscillator can play the role in identifying overbought and oversold levels. 30 is typically considered the oversold threshold. Reading above 30 indicates a stock is trading near the bottom of its high-low range. An upward stochastic crossover represents bullish sentiment in particular counter.
Caution to be taken when applying this strategy:
1. Most of the stocks that are in strong uptrend can have stochastic oscillator below 30 for an extended period. It is therefore required to check whether there are any other buying signals generated, eg: bullish divergence. Bullish divergence occurs when stock price makes a new low but the stochastic oscillator does not. Support and trendlines should also be checked to determine whether it is the time to enter the market.