Stochastic Oscillator

Definition:

The Stochastic Oscillator technical indicator, sometimes referred to as the Stochastics, has considerable similarities to the Williams %R oscillator. The Stochastic Oscillator was originally developed by George C. Lane in the late 1950s to assist traders in identifying when the market is trading near overbought or oversold extreme points.

In essence, the Stochastic Oscillator indicator plots the relationship of the market’s close relative to the high-low range seen over a chosen number of time periods. When the market regularly closes near the top of the indicator’s range, this indicates buying pressure or accumulation. Similarly, when a string of closes that approach the indicator’s range bottom appear, that indicates selling pressure or distribution is occurring.

Three types of Stochastic Oscillators can be found in common usage. These are the Fast, Slow and Full Stochastics which each have %K and %D lines. %K relates to the market’s close relative to the high-low range seen over a chosen number of time periods, while %D is a moving average of %K used to generate trading signals.

The Slow Stochastic just takes a moving average of the Fast Stochastic to help smooth out false signals, while the third type, the Full Stochastic just takes in a third parameter to avoid doing this extra step. The indicator’s scale customarily ranges from 0 to 100, and it gives an oversold reading for levels from 20 to 0 and an overbought reading for levels seen between 80 and 100.

Sample Chart:

Usage:

When using the Stochastic Oscillator, most traders consider readings seen over 80 to be overbought and those under 20 to be oversold. Nevertheless, that does not yet indicate a coming reversal. Instead, one should ideally look for the market to cross back into neutral territory before generating a trade signal.

In addition, the Stochastics Oscillator can be used to generate trading signals whenever the %K line moves above the %D line for a buy, or below the %D line for a sell. Nevertheless, this method can make several unsuccessful trades before it indicates one that succeeds. This disadvantage can be overcome by looking for a divergence between the price and the oscillator in overbought or oversold territory.

For a sell signal based on divergence, this means that the price has still made two higher highs with the Stochastics above 80 for both, but the second high on the Stochastics was not as high as the first. For the corresponding buy signal, the price would be making lower lows, and the Stochastics are below 20 for each, but the second did not make a new low on the Stochastics.

Calculation Method:

Define:

n= the number of the time period bar in question.
N= the number of time periods for observing highs and lows.
N1= the number of time periods used in the smoothing process for fast Stochastics.
N2= the number of time periods used in the smoothing process for slow Stochastics.
N3= the number of time periods used in the smoothing process for full Stochastics.
High(N,n)= The highest high price seen over N time periods at time n.
Low(N,n)= The lowest low price seen over N time periods at time n.
Close(n)= The closing price at the end of time period n.
SMA(A,B)= Simple Moving Average of data item A over B periods.
%K(n)= The first Fast Stochastics line.
%D(n)= The second Fast Stochastics line.
%KSLOW(n)= The first Slow Stochastics line.
%DSLOW(n)= The second Slow Stochastics line.
%KFULL(n)= The first Full Stochastics line.
%DFULL(n)= The second Full Stochastics line.

Calculate:

For Fast Stochastics:
%K(n) =[Close(n) - Low(N,n)]/[High(N,n)-Low(N,n)]*100
%D(n) = SMA(%K(n),N1)

For Slow Stochastics:
%KSLOW(n) = SMA(%K(n),3)
%DSLOW(n) = SMA( %KSLOW,N2)

For Full Stochastics
%KFULL(n) = SMA(%K(n),N2)
%DFULL(n) = SMA(%KFULL(n),N3)

Practice Stochastic Oscillator Trading

Technical analysis is a demanding skill that requires practice to master. We recommend that you use a demo account to train yourself for free before applying your skills to real money trading.
Most reputale trading platforms today (for example: GFC Trader, AVA Trader, Meta Trader) feature technical indicator functions which can be applied on real-time charts. You can open a free account, download the trading software and start sharpening your technical analysis skills today!

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