Stochastic oscillator: A technical tool designed to
highlight shorter-term momentum and “overbought” and
“oversold” levels (points at which a price move has, theoretically
at least temporarily exhausted itself and is ripe for
a correction or reversal).
Calculation: The stochastic oscillator consists of two
lines: %K and a moving average of %K called %D. The basic
stochastic calculation compares the most recent close to the
price range (high of the range - low of the range) over a particular
period.
For example, a 10-day stochastic calculation (%K) would
be the difference between today’s close and the lowest low
of the last 10 days divided by the difference between the
highest high and the lowest low of the last 10 days; the
result is multiplied by 100. The formula is:
%K = 100*{(Ct-Ln)/(Hn-Ln)}
Ct is today’s closing price
Hn is the highest price of the most recent n days (the
default value is five days)
Ln is the lowest price of the most recent n days
The second line, %D, is a three-period simple moving
average of %K. The resulting indicator fluctuates between 0
and 100.
Fast vs. slow: The formula above is sometimes referred to
as “fast” stochastics. Because it is very volatile, an additionally
smoothed version of the indicator –– where the original
%D line becomes a new %K line and a three-period average
of this line becomes the new %D line –– is more commonly
used (and referred to as “slow” stochastics, or simply “stochastics”).
Any of the parameters –– either the number of periods
used in the basic calculation or the length of the moving
averages used to smooth the %K and %D lines –– can be
adjusted to make the indicator more or less sensitive to
price action.
Horizontal lines are used to mark overbought and oversold
stochastic readings. These levels are discretionary;
readings of 80 and 20 or 70 and 30 are common, but different
market conditions and indicator lengths will dictate different
levels.