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Stochastic Oscillator
Description
Sto.chas.tic (st kas'tik) adj. 2. Math.
designating a process having an infinite progression of jointly
distributed random variables. -- Webster's dictionary.
The Stochastic Oscillator compares where a security's price closed
relative to its trading range over the last x-time periods.
The formula for the %K parameter of the Stochastic is:
For example, to calculate a 10-day %K: First, find the security's
highest high and lowest low over the last 10 days. For this example,
let's assume that during the last 10 days the highest high was 46
and the lowest low was 38--a range of 8 points. If today's closing
price was 41, %K would be calculated as:
The 0.375 in this example shows that today's close was at the
level of 37.5% relative to the security's trading range over the
last 10 days. If today's close was 42, the Stochastic Oscillator
would be 0.50. The 0.50 would show that the security closed today at
50%, or the mid-point, of its 10-day trading range.
The above example used a %K Slowing Period of 1 day (no slowing). If
you use a Slowing Period of greater than 1 period, you would total
the value of the numerators for the number of Slowing Periods, then
total the value of the denominators for the number of Slowing
Periods, and then perform the division. For example, to calculate a
10-day %K with 3-period slowing, you would sum the value of the
numerators (i.e., today's close minus the lowest low in the last 10
periods) for each of the last three periods, then sum the value of
the denominators (i.e., the highest high in the last 10 periods
minus the lowest low in the last 10 periods) for each of the last
three periods, and finally divide the sum of the numerators by the
sum of the denominators.
A moving average of %K is then calculated using the number of time
periods you specified in the %D Periods. This moving average is
called %D.
Finally, MetaStock Pro multiplies all stochastic values by 100 to
change decimal values into percentages for better scaling (e.g.,
0.375 is displayed as 37.5%).
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 x-time periods. A
reading of 100% shows that the security's close was the highest
price that the security has traded during the preceding x-time
periods.
Interpretation
Stochastic Oscillators can be used as both short - and
intermediate-term trading oscillators depending on the number of
time periods used when calculating the oscillator. When displaying a
short term Stochastic Oscillator (e.g., 5-25 days), it is popular to
slow the %K value by 3-days.
There are several ways to interpret a Stochastic Oscillator. Three
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, and
sell when the Oscillator rises above a specific level (e.g., 80)
and then falls below that level. However, before basing any
trade off of strict overbought/oversold levels it is recommended
that you first qualify the trendiness of the market using
indicators such as r-squared
or CMO. If these indicators suggest a
non-trending market, then trades based on strict overbought /
oversold levels should produce the best results. If a trending
market is suggested, then you can use the oscillator to enter
trades in the direction of the trend.
- Buy when the %K line rises above the %D (dotted) 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.
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