Stochastics Indicator

Technical Analysis, Studies, Indicators:

Stochastics

Description

The Stochastics indicator was introduced by George C. Lane in the late1950s. In technical analysis this oscillator is a momentum indicator that compares an equities current close to its high/low range over a set number of periods.

Technical Analysis

In technical analysis Stochastics is used to show how far the most recent close is away from the lowest low and highest high (over the calculated period):

• A security is close to a 20-day high if its 20-day Stochastics is greater than 80%;
• A security is close to a 20-day low if its 20-day Stochastics is below 20%.

We can differentiate three types of stochastic oscillators: Fast, Slow or Full.

%K and %D make up the Fast stochastic oscillator. The driving force behind both stochastic oscillators is %K (fast), which can be calculated with the formula provided above.

A 3-day simple moving average applied to the %K Fast Stochastics calculates the Slow Stochastics. %D (slow) is identical to %K (fast). An X-day simple moving average applied to the %K Fast Stochastics calculates Slow Stochastics.

Stochastics readings above 80 are typically considered to indicate an overbought situation whereas Stochastics readings below 20 are generally thought to indicate an oversold situation; however, a reading below 20 is not necessarily bullish nor is a reading above 80 automatically a bearish sign. A stock may continue to rise after its Stochastics has reached 80; conversely; it may continue to fall even after its Stochastics has reached 20.The probability of a reversal is much higher when volume surges occur close to index highs or lows (as indicated by the Stochastics).

• As a general rule, volume surges (indicated by a high PVO) that appear during a price advance when combined with closes near the highs (i.e., Stochastics > 80%) indicate potential downside reversals;
• As a general rule, volume surges (indicated by a high PVO) that appear during a price decline when combined with closes near the lows (i.e., Stochastics < 20%) indicate potential upside reversals.
• Ignore volume surges that appear when Stochastics readings exceed 20% and are below 80%. Market reactions might be short-lived under these circumstances.

Chart 1: S&P 500 Index (^SPX) - Stochastics Fast and Slow

Formula and Calculations

Stochastics is calculated according to the following formula:

Raw Stochastics(n) = 100 * (Recent Close - Lowest Low) / (Highest High - Lowest Low);

%K = 3-period moving average of Raw Stochastics;

%D = 3-periods moving average of %K;

n = number of periods used in the calculation to define highest high and lowest low.

Because it is a percentage or ratio, %K will fluctuate between 0 and 100. A 3-day simple moving average of %K is usually plotted alongside %D to act as a signal or trigger line.

By V. K. for MarketVolume.com