It is a momentum oscillator developed by George Lane. It determines where the price closed relative to a specific price range over a chosen time period. It is based on the premise that prices tend to close near the upper end of the candlestick during upward price movements whereas they tend to close near the lower end of the candlestick during downward movements. It consists of two lines; %K and %D.
%K=(Current Close-Lowest Low)/(Highest High-Lowest Low) x 100
Current Close – represents the latest closing price
Lowest Low – represents the lowest price for a specific time period
Highest High – represents the highest price for a specific period
Specific Period – is by default 5
Range – is the difference of Highest High – Lowest Low
The %D is a 3 (default value) period Simple Moving Average of %K.
The formula for %D is:
%D = SMA (%K,3)
This is known as fast stochastics.
By taking an additional 3-period Simple Moving Average of %D and %K, slow stochastics are calculated:
%K = SMA(%K,3)
%D = SMA(%D,3)
The Stochastic Oscillator ranges between 0 and 100.
A reading of 0 means that the latest closing prices is equal to the lowest price of the price range over the chosen time period. A reading of 100 means that the latest closing price is equal to the highest price recorded for the price range over the chosen time period.
Also, a reading above 80 is considered to be an indication that the market has reached extreme overbought levels, whereas a reading below 20 means that the market has declined to extreme oversold levels.
The Stochastic Oscillators follows the general rules of oscillator analysis:
- Signals are generated by the crossover between the %K and the %D line.
- A buy signal is generated when %K crosses above the %D line at the oversold area below 20 and then %D rises above the 20-line.
- A sell signal is generated when %K crosses below the %D line at the overbought area above 80 and then %D falls below the 80-line.
- Divergence between price and Stochastics especially at the oversold and overbought areas hints for a potential turning point in the market.
