In
technical analysis
In finance, technical analysis is an analysis methodology for analysing and forecasting the direction of prices through the study of past market data, primarily price and volume. Behavioral economics and quantitative analysis use many of the sam ...
of
securities
A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some countries and languages people commonly use the term "security" to refer to any for ...
trading, the stochastic
oscillator is a
momentum indicator that uses
support and resistance levels.
George Lane developed this indicator in the late 1950s. The term ''
stochastic'' refers to the point of a current price in relation to its price range over a period of time. This method attempts to predict price turning points by comparing the closing price of a security to its price range.
The 5-period stochastic oscillator in a daily timeframe is defined as follows:
:
where
and
are the highest and lowest prices in the last 5 days respectively, while %''D'' is the ''N''-day moving average of %''K'' (the last ''N'' values of %''K''). Usually this is a simple moving average, but can be an exponential moving average for a less standardized weighting for more recent values.
There is only one valid signal in working with %''D'' alone — a divergence between %''D'' and the analyzed security.
[Lane, George M.D. (May/June 1984) “Lane’s Stochastics,” second issue of Technical Analysis of Stocks and Commodities magazine. pp 87-90.]
Definition
The calculation above finds the range between an asset's high and low price during a given period of time. The current security's price is then expressed as a percentage of this range with 0% indicating the bottom of the range and 100% indicating the upper limits of the range over the time period covered. The idea behind this indicator is that prices tend to close near the extremes of the recent range before turning points. The Stochastic oscillator is calculated:
::''Where''
:::
is the last closing price
:::
is the lowest price over the last ''N'' periods
:::
is the highest price over the last ''N'' periods
:::
is a 3-period
simple moving average
In statistics, a moving average (rolling average or running average) is a calculation to analyze data points by creating a series of averages of different subsets of the full data set. It is also called a moving mean (MM) or rolling mean and is ...
of %''K'',
.
:::
is a 3-period
simple moving average
In statistics, a moving average (rolling average or running average) is a calculation to analyze data points by creating a series of averages of different subsets of the full data set. It is also called a moving mean (MM) or rolling mean and is ...
of %''D'',
.
A 3-line Stochastics will give an anticipatory signal in %''K'', a signal in the turnaround of %''D'' at or before a bottom, and a confirmation of the turnaround in %''D''-Slow. Typical values for ''N'' are 5, 9, or 14 periods. Smoothing the indicator over 3 periods is standard.
According to George Lane, the Stochastics indicator is to be used with
cycles,
Elliott Wave Theory and
Fibonacci retracement for timing. In low margin, calendar futures
spreads, one might use Wilders
parabolic as a trailing
stop
Stop may refer to:
Places
* Stop, Kentucky, an unincorporated community in the United States
* Stop (Rogatica), a village in Rogatica, Republika Srpska, Bosnia and Herzegovina
Facilities
* Bus stop
* Truck stop, a type of rest stop for truck d ...
after a stochastics entry. A centerpiece of his teaching is the divergence and convergence of trendlines drawn on stochastics, as diverging/converging to trendlines drawn on price cycles. Stochastics predicts
tops
Total Operations Processing System (TOPS) is a computer system for managing railway locomotives and rolling stock, known for many years of use in the United Kingdom.
TOPS was originally developed between the Southern Pacific Railroad (SP), S ...
and
bottoms.
Interpretation
The signal to act is when there is a divergence-convergence, in an extreme area, with a crossover on the right hand side, of a cycle bottom.
As plain crossovers can occur frequently, one typically waits for crossovers occurring together with an extreme pullback, after a peak or trough in the %D line. If price
volatility is high, an
exponential moving average
In statistics, a moving average (rolling average or running average) is a calculation to analyze data points by creating a series of averages of different subsets of the full data set. It is also called a moving mean (MM) or rolling mean and is ...
of the %D indicator may be taken, which tends to smooth out rapid fluctuations in price.
Stochastics attempts to predict turning points by comparing the closing price of a security to its price range. Prices tend to close near the extremes of the recent range just before turning points. In the case of an uptrend, prices tend to make higher highs, and the settlement price usually tends to be in the upper end of that time period's trading range. When the momentum starts to slow, the settlement prices will start to retreat from the upper boundaries of the range, causing the stochastic indicator to turn down at or before the final price high.
![Stochastic-divergence](https://upload.wikimedia.org/wikipedia/commons/a/a8/Stochastic-divergence.jpg)
An alert or set-up is present when the %D line is in an extreme area and diverging from the price action. The actual signal takes place when the faster % K line crosses the % D line.
Divergence-convergence is an indication that the momentum in the market is waning and a reversal may be in the making. The chart below illustrates an example of where a divergence in stochastics, relative to price, forecasts a reversal in the price's direction.
An event known as "stochastic pop" occurs when prices break out and keep going. This is interpreted as a signal to increase the current position, or liquidate if the direction is against the current position.
See also
*
MACD
MACD, short for moving average convergence/divergence, is a trading indicator used in technical analysis of securities prices, created by Gerald Appel in the late 1970s. It is designed to reveal changes in the strength, direction, momentum, a ...
*
Relative Strength Index (RSI)
*
Williams %R – Equivalent of %K, mirrored around the 0%-axis
*
Detrended price oscillator
References
External links
Stochastic Oscillator at InvestopediaStochastic Oscillator at StockCharts.com
{{DEFAULTSORT:Stochastic Oscillator
Technical indicators