Developed by George C. Lane in the late 1950s. The Stochastic Oscillator is a Momentum indicator that shows the location of the close relative to the High-Low range over a set number of periods.
According to an interview with Lane, the Stochastic Oscillator “doesn't follow price, it doesn't follow volume or anything like that. It follows the speed or the momentum of price. As a rule, the momentum changes direction before price.”
As such, Bullish and Bearish divergences in the Stochastic Oscillator can be used to foreshadow reversals. This was the first, and most important, signal that Lane identified. Lane also used this oscillator to identify bull and bear set-ups to anticipate a future reversal. Because the Stochastic Oscillator is range bound, is also useful for identifying overbought and oversold levels.
Stochastics is actually made up of Two lines, which tend to move in tandem. %K represents the level of the stock or index's closing price relative to the high and low range over a period of time, and %D attempts to smooth out the %K line by taking a three-day Moving Average of the %K line. Consequently, %D is generally considered the more important of the two. The theory behind stochastics is that these lines generate buy or sell signals when closing prices are near recent extreme highs or lows (i.e., sell signals after an uptrend and buy signals after a downtrend).
Generally, the area above 80 indicates an Overbought region, while the area below 20 is considered an Oversold region. When stochastics is above 80 and moves below that number, it indicates a sell signal. When stochastics is below 20 and moves above that number, it indicates a buy signal. Note that 80 and 20 are the most common levels used, but can be adjusted per individual preferences.
The Stochastics indicator is composed of two parts. The %K component is an oscillator itself, and it is usually provided separately as the Williams Oscillator in most trading software packages. Let’s first see how it is calculated, although we’ll discuss it separately under its own heading.
%K = 100 x ( Recent Close – Lowest Low )/( Highest High- Lowest Low)
Here the highest high, the lowest low, indicate the values created during the entire timeframe on which the indicator is being applied.
Stochastic Fast
Stochastic Fast plots the location of the current price in relation to the range of a certain number of prior bars (dependent upon user-input, usually 14-periods). In general, stochastics are used in an attempt to uncover overbought and oversold conditions. Above 80 is generally considered Overbought and below 20 is considered Oversold. The inputs to Stochastic Fast are as follows :
Fast %K[/color : [(Close - Low) / (High - Low)] x 100
Fast %D : Simple moving average of Fast K (usually 3-period moving average)
Stochastic Slow
Stochastic Slow is similar in calculation and interpretation to Stochastic Fast. The difference is listed below :
Slow %K : Equal to Fast %D (i.e. 3-period moving average of Fast %K)
Slow %D : A moving average (again, usually 3-period) of Slow %K
The important thing to note when reading the Stochastic is when the %K crosses above %D after it reaches the Oversold level or when the %K crosses below %D after it reaches the Overbought level.
Full Stochastic Oscillator
The Full Stochastic Oscillator is a fully customizable version of the Slow Stochastic Oscillator.
Full %K = Fast %K smoothed with X-period SMA
Full %D = X-period SMA of Full %K
Users can set the look-back period, the number of periods to slow %K and the number of periods for the %D moving average. The default parameters were used in these examples: Fast Stochastic Oscillator (14,3), Slow Stochastic Oscillator (14,3) and Full Stochastic Oscillator (14,3,3).
One thing to watch for is divergences between the direction of the Stochastics indicator and the Price of the stock/security. Divergences form when a New high or low in price is Not confirmed by a New high or low in stochastics. A Bullish divergence forms when price makes a lower low but Stochastics forms a higher low). This could indicate less downward momentum and could foreshadow a Bullish reversal.
