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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. 70 is typically considered the overbought threshold. Reading above 70 indicates a stock is trading near the top of its high-low range.
Caution to be taken when applying this strategy:
1. Most of the stocks that are in strong uptrend can have stochastic oscillator above 70 for an extended period. It is therefore required to check whether there are any selling signals generated, eg: bearish divergence. Bearish divergence occurs when stock price makes a new high but the stochastic oscillator does not. Support and trendlines should also be checked to determine whether it is the time to exit the market.