Introduction
In the late 1950s, George C. Lane developed the stochastic oscillator. To explain, the oscillator is under the classification of momentum indicators. It is focused on providing the point of close about the high-low range over some periods. According to George Lane himself, stochastic oscillators were not developed to follow volume, price, or the like. Instead, it focuses on following the momentum or speed of price. As a common rule that every trader must remember, the change in momentum direction happens before the price does.
Additionally, the stochastic oscillator may have bullish and bearish divergences. In such a case, it can be used in foreshadowing reversals. Keep in mind that this was the most important and first signal that George Lane identified. The oscillator was also used in determining both bull and bear set-ups which is mainly for the anticipation of future reversals. The stochastic oscillator can also be used for determining both overbought and oversold levels as it is range-bound.
Calculation
Provided below is the calculation process involved when using the stochastic oscillator:
1. %K
It is calculated by getting the difference between the current close and lowest low. The answer is to be divided by the difference between the highest high and lowest low. The result should then be multiplied by 100. The formula is given as follows:
%K = (Current Close – Lowest Low)/(Highest High – Lowest Low) * 100
2. %D
%D can be acquired by getting the 3-day simple moving average of the %K. To better understand the process, the formula is provided below:
%D = 3-day SMA of %K
Here are some additional notes to remember:
- The lowest low in the equation above refers to the lowest low of the look-back period.
- In the provided formula, the highest high pertains to the highest high of the look-back period.
- To move the decimal point to two places, the %K must be multiplied by 100.
Additionally, in using the stochastic oscillator, traders will notice that the default setting is 14 periods. This can be any of the time frames such as days, weeks, months, or even intraday. When the default setting is applied, the %K will be using the most recent close and the highest high, and the lowest low over the 14 periods. Note that the %K has a 3-day simple moving average and that is the %D which is plotted with %K. Both of them function as trigger or signal lines.
Interpretation
As explained earlier, the stochastic oscillator is responsible for measuring the level of close concerning the high-low range at a specified period. For instance, think of the highest high having a value of 110, the lowest low is 100, and the close has 108 as its value. 10 is the value for the high-low range which is also the denominator used in the formula of getting %K. The numerator is acquired by subtracting the lowest low from the close which equals 8 (108 – 100 = 8). When 8 is divided by 10, then the answer would be .80 or simply 80%. If the close is found on the range’s upper half, then it can be implied that the stochastic oscillator is over 50. On the other hand, if the close is found in the lower half, then the stochastic oscillator is said to be below 50. When the readings are under 20, it is an indication that the price is near its low over a particular period. On the other hand, readings over 80 imply that the price and its high are near to each other for a particular period
The stochastic oscillator, as an indicator, has three available versions. The default settings are provided below:
- Fast Stochastic Oscillator (14,3)
- Slow Stochastic Oscillator (14,3)
- Full Stochastic Oscillator (14,3,3)
For the basic calculation of %K, the 14-period is used. Be reminded that the %K is unsmoothed in the fast stochastic oscillator while the %K is smoothed with a 3-day simple moving average in the slow stochastic oscillator. The number responsible for setting the moving average period for %D is the number 3 in the fast and slow stochastic oscillator settings (14,3). People who aim to have maximum flexibility may opt to use the stochastic oscillator in setting the look-back period: the moving average for %D and smoothing factor for %K. It is also worth noting that the stochastic oscillator may be placed above, behind, or below the price plot. When the indicator is placed behind the price, then the traders can match the stochastic oscillator swings and price swings.
Conclusion
Momentum oscillators are most applicable to use when trading ranges. Aside from this, knowing that the trend takes on a zigzag format, it may also be used with securities that trend. When there are pullbacks, know that it is a part of the uptrends that zigzag higher. On the other hand, when downtrends zigzag lower, bounces are expected. For this reason, the indicator becomes useful in determining potential opportunities relative to bigger trends.
Additionally, traders may use the stochastic oscillator in determining the turns near either the support or resistance. When the stochastic oscillator is oversold and a security trades near support, the traders should find a break over the value of 20. In this way, an upturn will be signaled together with a successful support test. On the other hand, when the stochastic oscillator is overbought and a security trades near resistance, then traders must find a break below 80. In this way, a downturn and resistance failure will be signaled.
Moreover, the personal preferences, time frame, and trading style of a trader must be matched with the settings of the stochastic oscillator. It is also important to remember that a choppy oscillator with numerous oversold and overbought readings is to be produced by the shorter look-back period. On the other hand, a longer look-back period provides a smoother oscillator having less oversold and overbought readings.
Furthermore, in a similar way to other indicators, the stochastic oscillator is better used with other technical analysis tools. In this way, the produced signals can be confirmed providing the traders with a more correct analysis. If traders want to practice using indicators, one may opt to visit the broker website and create a demo account. If one has already gained enough confidence and trading knowledge, the learning can also be applied to real-time trading accounts.