This is an Oscillator developed by George C. Lane. It is a momentum indicator. The Stochastic Oscillator is a momentum indicator that shows the location of the close relative to the high-low range over a set number of periods This is used to identify the extreme prices range (higher and lower) over a period of time. It is made of two components basically
% K indicators line
This can be calculated by having a recent close price, highest price and lowest price over a period of time (days). Default is 14 days or also known as 14 periods. % t) signal line : This is the moving average of % K- Default is 3 days or 3 periods.Stochastic indicator oscillates between 0 to 100 ranges. Accordingly the Overbought and overbought levels can be determined. Above 80 is considered to be overbought and below 20 is considered to be oversold levels. There are three types of Stochastics oscillators namely.
Fast Stochastic Oscillator
- Fast %K = %K basic calculation
- Fast %D = 3-period SMA of Fast %K
Slow Stochastic Oscillator
- Slow %K = Fast %K smoothed with 3-period SMA
- Slow %D = 3-period SMA of Slow %K
Full Stochastic Oscillator
- Full %K = smoothed with X-period SMA
- Full %D = X-period SMA of Full %K
The Full Stochastic Oscillator is a fully customizable version of the Slow Stochastic Oscillator Users can set the look-back period the number of periods to slow %K and the number of periods for the %D moving average. The default parameters used are Fast Stochastic Oscillator (14, 3), Slow Stochastic Oscillator (14. 3) and Full Stochastic Oscillator (14, 3, 3).
Use of Stochastic in Trading
Overbought and Oversold levels : Stochastic indicators are most popularly used for finding the overbought and oversold levels of the stock. Stochastic below 20 is suggested as an oversold condition which gives a signal of better buying opportunity while Stochastic above 80 is an indication of overbought level and a trader may pay attention in selling their open position. Always take precaution and remember this indicator works better in sideways market rather than in trending market sometimes the overbought period is ten long indicating an uptrend.
RSI tends to fluctuate between 40 and 90 in a bull market (uptrend) with the 40-50 zones acting as support These ranges may vary depending on RSI parameters, strength of trend and volatility of the underlying security On the other side, RSI tends to fluctuate between 10 and 60 in a bear market (downtrend) with the 50-60 zones acting as resistance.
when Stochastic Indicator % D Signal line when crosses the centre line a bullish signal is indicated, similarly when it crosses below the centre line a bearish signal is dictated. Also when the % D Signal Line crossovers % K Indicator Line such that % K Indicator Line is above the % D Signal Line in the oversold area is an indication of buy signal. When the % K Indicator Line crossovers % D Signal Line such that % D Signal Line is above the % K Indicator Line in the overbought area indicates a sell signal.
Divergence in stochastic indicators also gives buy and sell signal called positive and negative divergence similar to as explained in RSI divergence.