Stochastic Oscillator

From Traderpedia

The Stochastic is a momentum indicator devised by George Lane in the 1950's. It gives overbought or oversold signals depending on its position relative to the 0 level. The Stochastic can also be used to give convergence and divergence indications, such as when a stock/index price makes a new low however the Stochastic does not - this is a bullish divergenece. Conversely when the stock/index price makes a new high but the Stochastic does not or moves horizontally this is a bearish divergence and the price of the stock/index will soon follow the Stochastic.

In general terms a Stochastic level below 20 would be considered oversold, where as a level above 80 woudl be considered overbought. However, Lane did not believe that a reading above 80 was necessarily bearish or a reading below 20 bullish. A buy or sell signal can be generated by the Stochastic when the indicator passes back above the 20 level for a buy signal or below the 80 level for a sell signal.

There are different types of Stochastic Oscillator and reference may be made to a Fast Stochastic or a Slow Stochastic. These are generated by using different settings - as detailed in the calculation below. The Fast Stochastic can be useful for quick trades - made in short time frames. The Slow Stochastic is more smoothed and loses a lot of 'noise' that can lead to confusion with the Fast Stochastic.

[edit] Calculation

The Stochastic Oscillator shows the location of the current close relative to the high/low range over a set number of periods, which is usually taken as being 14. It works by taking the close price of the past number of periods and if these are consistently near the top of the range it indicates strong buying pressure. Conversely if the close price for the past number of periods is near the bottom of the range then it indicates selling pressure.

The first parameter is the number of periods to be used to calculate the %K (usually 14). The second parameter is the number of periods to be used to calculate the moving average of %K - this can be taken as 1 to give a fast Stochastic or 3 - 5 to give a slow Stochastic. The third parameter is the number of periods to be taken to calculate the moving average of %D.