The Stochastics Oscillator

George Lane developed the Stochastics indicator in the early 1960's. The stochastics indicator is based on the observation that as the price of an instrument increases, the daily closes tend to be closer to the upper end of the recent price range. Conversely, as the price decreases, the daily closes tend to be closer to the lower end of the recent price range.

The stochastic values simply represent the position of the market on a percentile basis versus its range over the previous n-day sessions. The percentile scale begins with zero at the bottom of the n-day range and ends with 100 at the top of the range. The Stochastic Oscillator compares where a security's price closed relative to its price range over a given time period.

The Stochastic Oscillator is displayed as two lines. The main line is called "%K." The second line, called "%D," is a moving average of %K. The %K line is usually displayed as the primary red line and the %D line is usually displayed as the secondary green line.

There are three primary stochastic values:

Raw stochastic - the most basic value representing the stochastic value for each period. Also known as raw K.
%k - the first smoothing of the raw stochastic, usually with a 3-period exponential moving average.
%d - the smoothing of the %k value, usually with another 3- period exponential moving average. Also known as slow K.

There are two parameters for stochastics:

the n-day range over which the Raw K percentile is calculated the y-day exponential smoothing factor for %K and %D "Fast Stochastics" refers to comparing Raw K and %K, while "Slow Stochastics" refers to comparing the slower %K and %D values. However, it should be noted that there are a wide variety of different names for the stochastic values.

Note: Williams Percent R is simply the inverse of Raw K. Williams Percent R uses an upside down scale with zero at the top and 100 at the bottom.

The calculations and interpretations for Modified Stochastics are the same as those used on the regular Stochastic Indicator, except in the definition of the n-period price range, the modified stochastic defines the range by the highest close and the lowest close in the number of periods specified.

There are several ways to interpret a Stochastic Oscillator. 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. Sell when the Oscillator rises above a specific level (e.g., 80) and then falls below that level. Buy when the %K line rises above the %D 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. 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 n-day periods. A reading of 100% shows that the security's close was the highest price that the security has traded during the preceding n-day periods.

To calculate the stochastics:

Assuming parameters of 14,3 find the 14-period high, the 14- period low and the latest price.

The raw stochastic is calculated as (latest - 14-period low) / (14-period high - 14-period low) multiplied by 100. Therefore if the 14-period high was 200, the 14-period low was 100, and latest price is 150 (150-100)/(200-100)*100 = 50%

On the third period of data, the %k is the average of the raw values. After the 3rd period %k is the 3-period exponentially smoothed raw values (2/3 old %k + 1/3 new raw stochastic).

After 3 periods of %k, the %d is calculated as a 3-period exponentially smoothed version of %k.

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