Part of the momentum family of indicators, the Stochastic Oscillator was developed by George Lane at the end of the 1950s. It uses the close prices to visualize where the current price is relative to a range of highs and lows over a recent period. The idea behind this is that it shows the speed, or momentum of how the price is changing. The assumption is that momentum changes before the direction does, thus making the stochastic a predictive technical indicator.
Let’s see how it’s actually calculated:
%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
As usual, there’s no need to commit this formula to memory, as it gets calculated by platforms automatically. But we’re including it here to give some context and a feel for the indicator, as it’s important to understand its principle. That way you can better use it in real trading situations, rather than relying on it blindly and throwing it away at the first wrong signal.
So here are the defaults of the Stochastic Oscillator – 14 time periods (hours, days, weeks, months, etc.) The 14 period (marked as line %K on the indicator) uses the last closing price, the highest and the lowest levels from that period. The %D line is calculated as the simple moving average for the last three days.
The %K and %D lines are plotted together on the indicator and the places they cross each other are perceived as signal points.
Interpreting it is relatively straightforward. It’s above 50 when the close is in the top half and vice versa. When the level is under 20 then the price should be near its low. Levels over 80 are thought of as nearing the high.
There are several variations of the original Stochastic Oscillator. The two most popular are the Fast and Slow Stochastics.
The Fast Stochastic is based on the original formula but it was a bit choppier than most traders preferred. It gave too many signals and made it harder to react to. That’s why the calculation of %K in the Slow Stochastic is smoothed with a 3-day simple moving average:
Slow %K = Fast %K smoothed with 3-period SMA
Slow %D – 3-period SMA of Slow %K
Over time the Slow Stochastic seems to have gained more fans than its predecessor, but all are available through the majority of platforms and brokers. It would be best to try them out and see for yourself which (if any) of them would be the best fit for your trading style.
Although many traders use it to identify overbought and oversold levels, the foremost style to use the Stochastic Oscillator (Fast, Slow or a custom setup of variables) is with its bullish and bearish divergences according to its creator.
