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Stochastic Oscillator (Slow Stochastic)
Developed by George C. Lane in the late 1950s, the Stochastic Oscillator
is a momentum indicator that shows the location of the close relative to the
high-low range over a set number of periods. According to an interview with
Lane, the Stochastic Oscillator "doesn't follow price, it doesn't follow
volume or anything like that. It follows the speed or the momentum of price.
As a rule, the momentum changes direction before price." As such, bullish
and bearish divergences in the Stochastic Oscillator can be used to foreshadow
reversals. This was the first, and most important, signal that Lane identified.
Lane also used this oscillator to identify bull and bear set-ups to anticipate
a future reversal. Because the Stochastic Oscillator is range bound, is also
useful for identifying overbought and oversold levels.
There are several variations of a Stochastic Oscillator, but the two most
common are called the Slow Stochastic and Fast Stochastic. Of these two, the
Slow Stochastic is most commonly used, as it is smoother and less prone to false
positives.
Calculation
%K = (Current Close - Lowest Low)/(Highest High - Lowest Low) * 100
%D = 3-day SMA of %K
Lowest Low = lowest low for the look-back period
Highest High = highest high for the look-back period
%K is multiplied by 100 to move the decimal point two places
The default setting for the Stochastic Oscillator is 14 periods, which can
be days, weeks, months or an intraday timeframe. A 14-period %K would use the
most recent close, the highest high over the last 14 periods and the lowest
low over the last 14 periods. %D is a 3-day simple moving average of %K. This
line is plotted alongside %K to act as a signal or trigger line.
A common use of Stochastic is to observe crossovers between the %K and %D
lines. Generally, %K crossing above %D indicates a price change to the
upside, and %D crossing above %K indicates downside.
In
this example of Stochastic, notice how the stock price direction follows the
%K and %D crossovers. Each time %K (green) crosses above %D (red), the price
has a tendency to rise for multiple periods.
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