STOCHASTIC OSCILLATOR
Overview
Sto.chas.tic (sto kas'tik) adj. 2. Math. designating a process having an infinite progression of jointly
distributed random variables.
--- Webster's New World Dictionary
The Stochastic Oscillator compares where a security's price closed relative to its price range over a
given time period.
Interpretation
The Stochastic Oscillator is displayed as two lines. The main line is called "%K." The second line,
called "%D," is a moving average of %K. The %K line is usually displayed as a solid line and the
%D line is usually displayed as a dotted line.
There are several ways to interpret a Stochastic Oscillator. Three popular methods include:
1. Buy when the Oscillator (either %K or %D) falls below a specific level (e.g., 20) and then rises
above that level. Sell when the Oscillator rises above a specific level (e.g., 80) and then falls
below that level.
2. Buy when the %K line rises above the %D line and sell when the %K line falls below the %D
line.
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Look for divergences. For example, where prices are making a series of new highs and the
Stochastic Oscillator is failing to surpass its previous highs.
Example
The following chart shows Avon Products and its 10-day Stochastic.
I drew "buy" arrows when the %K line fell below, and then rose above, the level of 20. Similarly, I drew
"sell" arrows when the %K line rose above, and then fell below, the level of 80.
This next chart also shows Avon Products.
In this example I drew "buy" arrows each time the %K line rose above the %D (dotted). Similarly, "sell"
arrows were drawn when the %K line fell below the %D line.
This final chart shows a divergence between the Stochastic Oscillator and prices.
This is a classic divergence where prices are headed higher, but the underlying indicator (the
Stochastic Oscillator) is moving lower. When a divergence occurs between an indicator and prices, the
indicator typically provides the clue as to where prices will head.
Calculation
The Stochastic Oscillator has four variables:
1.
%K Periods.
This is the number of time periods used in the stochastic calculation.
2.
%K Slowing Periods.
This value controls the internal smoothing of %K. A value of 1 is considered a fast stochastic;
a value of 3 is considered a slow stochastic.
3.
%D Periods.
This is the number of time periods used when calculating a moving average of %K. The
moving average is called "%D" and is usually displayed as a dotted line on top of %K.
4.
%D Method.
The method (i.e., Exponential, Simple, Time Series, Triangular, Variable, or Weighted) that is
used to calculate %D.
The formula for %K is:
For example, to calculate a 10-day %K, first find the security's highest-high and lowest-low over the
last 10 days. As an example, let's assume that during the last 10 days the highest-high was 46 and the
lowest-low was 38--a range of 8 points. If today's closing price was 41, %K would be calculated as:
The 37.5% in this example shows that today's close was at the level of 37.5% relative to the security's
trading range over the last 10 days. If today's close was 42, the Stochastic Oscillator would be 50%.
This would mean that that the security closed today at 50%, or the mid-point, of its 10-day trading
range.
The above example used a %K Slowing Period of 1-day (no slowing). If you use a value greater than
one, you average the highest-high and the lowest-low over the number of %K Slowing Periods before
performing the division.
A moving average of %K is then calculated using the number of time periods specified in the %D
Periods. This moving average is called %D.
The Stochastic Oscillator always ranges between 0% and 100%. A reading of 0% shows that the
security's close was the lowest price that the security has traded during the preceding x-time periods.
A reading of 100% shows that the security's close was the highest price that the security has traded
during the preceding x-time periods.
Stochastics
The stochastic oscillator compares where a security's price has closed relative
to its price range over a specifically identified period of time. George Lane, who
developed this indicator, theorized that in an upwardly trending market, prices tend to
close near their high; and during a downward trending market, prices tend to close
near their low. Further, as an upward trend matures, price tends to close further away
from its high; and as a downward trend matures, price tends to close away from its
low.
The stochastic indicator attempts to determine when prices start to cluster around
their low of the day for an up trending market, and when the tend to cluster around
their high in a down trending market. Lane's theory is these are the conditions which
indicate a trend reversal is beginning to occur.
The stochastic indicator is plotted as two lines. They are the %D line and the %K
line. The %D line is more important than the %K line. The stochastic is plotted on a
chart with values ranging from 0 to 100. The value can never fall below 0 or above
100. Readings above 80 are strong and indicate that price is closing near its high.
Readings below 20 are strong and indicate that price is closing near its low.
Ordinarily, the %K line will change direction before the %D line. However, when the
%D line changes direction prior to the %K line, a slow and steady reversal is
usually indicated.
When both %K and %D lines change direction, and the faster %K line subsequently
changes direction to retest a crossing of the %D line, but doesn't cross it, this is a
good confirmation of the stability of the prior reversal.
A very powerful move is underway when the indicator reaches its extremes around 0
and 100. Following a pullback in price, if the indicator retests these extremes, a good
entry point is indicated.
Many times, when the %K or %D lines begin to flatten out, this is an indication
that the trend will reverse during the next trading range.
Quite often, divergence's set up on the chart. That is, price may be making higher
highs, but the stochastic oscillator is making lower lows. Or conversely, price may be
making lower highs, and the stochastic oscillator is making higher highs. In either
case, the indicator usually is demonstrating a change in price before price itself is
changing.
The formula for %k is as follows:
%K = 100[(C - L5close)/(H5 - L5)]
Where:

C = the most recent close

L5 = the lowest low for the last 5 trading periods

H5 = highest high for the same five trading periods
%D is a smoothed version of the %K line. Usually, 3 periods is used. The %K
formulas is as follows:
%D = 100 X (H3/L3)
Where:

H3 = the 3 period sum of (C - L5)

L3 = the 3 period sum of (H5 - L5)
An example of the way stochastics are used is shown below :