Technical Analysis, Studies, Indicators:
Stochastics
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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.
Stochastics is calculated according to the following formula:
Raw Stochastics = 100 * (Recent Close - Low(n)) / (High(n)
- Low(n));
%K = 3-period moving average of Raw Stochastics;
%D = 3-periods moving average of %k;
n = number of periods used in the calculation.
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.
Stochastics shows 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, and 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 (Fast) is identical to %K
(Slow). 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.
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