Stochastic Oscillator

A technical tool designed to highlight shorter-term momentum and “overbought” and “oversold” levels (points at which a price move has, theoretically at least, temporarily exhausted itself and is ripe for a correction or reversal).

Calculation: The stochastic oscillator consists of two lines: %K and a moving average of %K called %D. The basic stochastic calculation compares the most recent close to the price range (high of the range - low of the range) over a particular period.

For example, a 10-day stochastic calculation (%K) would be the difference between today’s close and the lowest low of the last 10 days divided by the difference between the highest high and the lowest low of the last 10 days; the result is multiplied by 100. The formula is:

%K = 100*{(Ct-Ln)/(Hn-Ln)}

where

Ct is today’s closing price

Hn is the highest price of the most recent n days (the default value is five days)

Ln is the lowest price of the most recent n days

The second line, %D, is a three-period simple moving average of %K. The resulting indicator fluctuates between 0 and 100.

Fast vs. slow: The formula above is sometimes referred to as “fast” stochastics. Because it is very volatile, an additionally smoothed version of the indicator –– where the original %D line becomes a new %K line and a three-period average of this line becomes the new %D line –– is more commonly used (and referred to as “slow” stochastics, or simply “stochastics”).

Any of the parameters –– either the number of periods used in the basic calculation or the length of the moving averages used to smooth the %K and %D lines –– can be adjusted to make the indicator more or less sensitive to price action.

Horizontal lines are used to mark overbought and oversold stochastic readings. These levels are discretionary; readings of 80 and 20 or 70 and 30 are common, but different market conditions and indicator lengths will dictate different levels.