Understanding Stochastic oscillators.

Stochastic indicator:

The Stochastic oscillator is a technical indicator that shows the momentum. It is designed to oscillate between 0 and 100. Low levels mark oversold markets, and high levels mark overbought markets. Overbought means prices are too high, ready to turn down. Oversold means prices are too low, ready to turn up. Technical analysts believe that a value of 20 or below indicates an oversold condition and that a value of 80 or above indicates an over bought condition. This indicator was popularized by George lane decades ago and is now included in most software packages.

What does it measure?

The Stochastic oscillator measures the capacity of bulls to close prices near the top of the recent trading range and the capacity of bears to close them near the bottom. Bulls may push prices higher during the day, or bears may push them lower, but the stochastic oscillator measures their performance at closing time—the crucial money-counting time in the markets. If bulls lift prices during the day but cannot close them near the high of the recent range, the stochastic oscillator turns down, identifying weakness and giving a sell signal. If bears push prices down during the day but cannot close them near the lows, the stochastic oscillator turns up, identifying strength and giving a buy signal. An example of how Stochastics appears below the stock price chart is shown below:

Fast & Slow Stochastics:

There are 2 main types of setting, the Fast Stochastic and the Slow stochastic.
Fast Stochastics: use shorter Time Periods, and Shorter Averages – this creates more fluctuations but conversely also more false alarms
Slow Stochastics: use longer time periods and longer average periods – this creates a smoother flow and gives the ability to see trends clearer, the drawback is the Indicator lags price and is less responsive.

How is the indicator plotted?

The term stochastic refers to the location of a current price in relation to its price range over a period of time. The stochastic is plotted as two lines %K, a fast line normally represented by a blue line and %D, a slow line, normally red. These two lines have the following characteristics:
The default setting for the Stochastic Oscillator is 14 periods, which can be days, weeks, months or an intraday time frame. The %K line is basically a representation of where the market has closed for each period in relation to the trading range for the 14 periods used in the indicator.
The %D line is a 5 period moving average of %K.
Sounds very complicated, isn’t it? Don’t worry. You don’t need to learn about how combustion engine works to drive a car. What you need to do is to follow these simple rules.
Rule 1- Use the stochastic oscillator just like RSI to identify overbought and oversold levels in the market. When the lines that make up the indicator are above 80, it represents a market that is potentially overbought and when they are below 20, it represents a market that is potentially oversold. The developer of the indicator George Lane recommended waiting for the %K line to trade back below or above the 80 or 20 lines as this gives a better signal that the momentum in the market is reversing.

Rule 2- Watch for a crossover of the %K line and the %D line. When %D is below the 20 mark and the faster %K line crosses the slower %D line, it is a sign that the market may be heading up and when %D is above the 80 mark and the %K line crosses below the %D line this is a sign that the market may be heading down.

Rule 3- The third rule is to watch for divergences where the Stochastic trends in the opposite direction of price. As with the RSI this is an indication that the momentum in the market is waning and a reversal may be in the making. For further confirmation many traders will wait for the cross below the 80 or above the 20 line before entering a trade on divergence.

Rule 4- Never rely solely on Stochastics or any other technical indicator for that matter. Always use technical indicators as additional tools. Stochastics uses the Price Open, High, Low and Close for the period, so it can be used well in conjunction with RSI, which uses only Close Price as the input.

That completes our lesson on Stochastics. The nicest thing about the stochastic is that it can keep up with fast moving, volatile or even trading range markets.

You may like these posts:

  1. Oscillators
  2. Types of indicators/Oscillators
  3. Understanding Average Directional Index (ADX)

2 Responses to “Understanding Stochastic oscillators.”

Travon

September 20, 2011 at 1:46 pm

Ppl like you get all the brains. I just get to say thanks for the ansewr.

shiva

February 26, 2016 at 12:45 pm

excellent…..great

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