Stochastic Oscillator

Description

Sto.chas.tic (st kas'tik) adj. 2. Math. designating a process having an infinite progression of jointly distributed random variables. -- Webster's dictionary.

The Stochastic Oscillator compares where a security's price closed relative to its trading range over the last x-time periods.

The formula for the %K parameter of the Stochastic is:

For example, to calculate a 10-day %K: First, find the security's highest high and lowest low over the last 10 days. For this 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 0.375 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 0.50. The 0.50 would show 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 Slowing Period of greater than 1 period, you would total the value of the numerators for the number of Slowing Periods, then total the value of the denominators for the number of Slowing Periods, and then perform the division. For example, to calculate a 10-day %K with 3-period slowing, you would sum the value of the numerators (i.e., today's close minus the lowest low in the last 10 periods) for each of the last three periods, then sum the value of the denominators (i.e., the highest high in the last 10 periods minus the lowest low in the last 10 periods) for each of the last three periods, and finally divide the sum of the numerators by the sum of the denominators.

A moving average of %K is then calculated using the number of time periods you specified in the %D Periods. This moving average is called %D.

Finally, MetaStock Pro multiplies all stochastic values by 100 to change decimal values into percentages for better scaling (e.g., 0.375 is displayed as 37.5%).

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.

Interpretation

Stochastic Oscillators can be used as both short - and intermediate-term trading oscillators depending on the number of time periods used when calculating the oscillator. When displaying a short term Stochastic Oscillator (e.g., 5-25 days), it is popular to slow the %K value by 3-days.

There are several ways to interpret a Stochastic Oscillator. Three popular methods include:

• Buy when the Oscillator (either %K or %D) falls below a specific level (e.g., 20) and then rises above that level, and sell when the Oscillator rises above a specific level (e.g., 80) and then falls below that level. However, before basing any trade off of strict overbought/oversold levels it is recommended that you first qualify the trendiness of the market using indicators such as r-squared or CMO. If these indicators suggest a non-trending market, then trades based on strict overbought / oversold levels should produce the best results.  If a trending market is suggested, then you can use the oscillator to enter trades in the direction of the trend.

• Buy when the %K line rises above the %D (dotted) line and sell when the %K line falls below the %D line.

• 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.