Stochastic Oscillator

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Introduction

A stochastic oscillator is a momentum indicator which is used to identify overbought and oversold levels comparing the closing price of a symbol to its price range over a certain number of periods.

The indicator consists of two lines:

  • %K which compares the latest closing price to the recent trading range.
  • %D which is a signal line calculated by smoothing of %K.

There are two types of stochastics: Stochastic Fast (SFK) and Stochastic Slow (SSD).

The main difference between Fast and Slow Stochastic is in their sensitivity. Fast Stochastic is more sensitive to changes in the symbol price and is likely to result in too many trading signals. Slow Stochastic which uses further smoothing can provide more accurate and reliable signals.

Stoch.png

Formula

Stochastic Fast (SFK)

%K of SFK is calculated as the Close price of the current period minus the lowest Low as a ratio and the price highest High minus the price lowest Low as the denominator, multiplied by 100.

Mathematically:


\operatorname{K%(SFK)} = \dfrac {currentClose - Low(in %K periods)}{High(in %K periods) - Low(in %K periods)} \times 100

where:

\operatorname{currentClose} is the Close price of the current period;

 \operatorname {Low(in %K periods)} is the lowest Low in %K periods;

\operatorname{High(in %K periods)} is the highest High in %K periods.


%D of SFK is calculated as a moving average of %K. The original formula uses a 3 period Simple Moving Average (MVA, SMA):


\operatorname{D%(SFK)} = \operatorname{SMA(%K,N)}

where:

\operatorname{N} is the smoothing period for %D of SFK;

 \operatorname {SMA} is the Simple Moving Average.

Stochastic Slow (SSD)

%K of SSD is equal to D% of SFK:


\operatorname{%K(SSD)} = \operatorname{D%(SFK)}

%D of SSD is calculated as a moving average of %K. The original formula uses a 3 period Simple Moving Average (MVA, SMA):


\operatorname{D%(SSD)} = \operatorname{SMA(%K,N)}

where:

\operatorname{N} is the smoothing period for %D of SSD;

 \operatorname {SMA} is the Simple Moving Average.

Usage

The two lines of Stochastic move within a range of 0 and 100. Values above 80 are considered to be in overbought territory and indicate that a reversal in price is possible. Values below 20 are considered oversold and also indicate a possible reversal.

Stochastic is recommended for use in ranging market conditions. In trending markets Stochastic will show overbought/oversold levels while the price continues to move in the direction of the trend, though sometimes these levels can be a signal of a possible reversal.

There are three kinds of trading signals provided by Stochastic.

  1. Stochastic reaching of either overbought or oversold level and than making a bit of reversal:
    • Falling of Stochastic below 20 and then rising above 20 can be interpreted as a signal to buy.
    • Rising of Stochastic above 80 and then falling below 80 can be interpreted as a signal to sell.
  2. Crossing of %K and %D:
    • When %K crosses over %D, this can be interpreted as a signal to buy.
    • When %K crosses under %D, this can be interpreted as a signal to sell.
    Such crossovers can occur too often. To get a more reliable signal, one can wait for crossovers occurring together with reaching of overbought/oversold levels.
  3. Divergence between Stochastic and the price:
    • When the price makes a new low, and Stochastic goes above its previous low, this can be interpreted as a signal to buy.
    • When the price makes a new high, and Stochastic does not rise as high as before, this can be interpreted as a signal to sell.

See Also

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