In mathematics the term stochastic signifies any process involving a randomly determined sequences of observations, each of which is considered a sample of one element from a probability distribution. However, in the world of technical trading the term is used describe an indicator which compares the most recent close with the highest high and lowest low over a predetermined period of time.
The Stochastic Oscillator was developed by the late George C. Lane, who developed the indicator during the late 1950’s. Like the Relative Strength Index (RSI), the Stochastic Oscillator is most commonly used to determine overbought and oversold conditions. Many also monitor any divergence between the oscillator and the price. The original Stochastic Oscillator as developed by Lane, consists of two lines. The line with the higher peaks and lowest lows is referred to as %K (more choppy), and the other (more smoothed) line is called the %D.
The Stochastic Oscillator compares a instruments most recent close relative to its price range over a selected period of time. The basic formula of the choppy %K is as follows:
%K= 100 (C-L)/(H-L)
- C stands for the Current or most recent close.
- H stands for the high over the given period of time.
- L stands for the lowest low over the given period of time.
In addition to this basic formula, the Stochastic Oscillator has four variables:
- %K periods: The number of periods used in calculating the Oscillator.
- %K slowing periods: This particular value controls the internal smoothing of the %K line. A value of 1 creates a fast or choppy stochastic, while a value of 3 creates a slow or smooth stochastic oscillator.
- %D periods: This is the number used to calculate the moving average of %K. This moving average is better known as %D and is usually displayed alongside the %K.
- %D method: The method used to smooth the %D line. In the majority of the time the smoothing method used is a simple or exponential moving average.
If we wanted to calculate the 10-Day moving %K, we would first find the instruments highest high and lowest low over the last 10 days. For this particular example were going to assume that the instruments high over the last 10 days was 100 and that its low was 50. If the last close was 75, %K would be calculated as the following:
100 * (75 – 50) / (100 – 50) = 50%
The 50% value in the above example shows that the most recent close was at a midpoint level relative to the particular instruments trading highs and lows over the last 10 days. If the last close was say 62.5, the Stochastic oscillator would give us a %K value of 25%, as the price would be at 25% of its 10 day trading range. In the above examples we used a one day period, with no slowing variable. Calculating the stochastic oscillator to include more variables becomes increasingly complicated, thankfully the majority of trading software should automatically calculate the Stochastic oscillator to your preference with no problem. Understanding the basic formula behind stochastic oscillators should help traders understand the indicator more.
The stochastic oscillator always ranges between 0 and 100 percent. A reading of 0 percent indicates that the most recent close was the lowest price that the security had traded at over the given time period. While a reading of 100 percent indicates the most recent close was the highest price that the instrument had traded at during the given time period.
There are a number of different popular interpretations of how to use to Stochastic oscillator, including:
- A Buy signal when the oscillator (either %K or %D) falls below a specific level (normally 20/30%) and then rises back up above this level.
- A Sell signal when the oscillator (either %K or %D) rises above a specific level (normally 70/80%) and then falls back below this level.
- A Buy signal when the %K line rises above the %D line, and a Sell signal when the %K line falls below the %D line.
It is in the above ways that the Stochastic oscillator is often used on its own or more often than not in conjunction with another signal, with the stochastic oscillator operating as a confirmation signal. As with many overbought and oversold signals, the stochastic oscillator can be unreliable in markets that trending strongly. Be on the look out for divergences which occur when prices are making new highs or lows and the stochastic oscillator does not exceed it’s previous highs or lows. Here a divergence occurs, which often indicates a change in the current trend.