What Is the Stochastics Oscillator?

01/27/2015 6:00 am EST

Focus: STRATEGIES

Bernard Stegmueller, of Fusion Trading Zone, discusses both types of stochastics—fast and slow—and highlights several major interpretations, which may be more beneficial when combined with other indicators that discern whether a market is in a trending or cyclical rotation mode.

Stochastics Oscillator

Definition: The Stochastics oscillator, a popular and dynamic indicator developed by Dr. George Lane, is based on the premise that during an upward trading market, prices tend to close near their high and during a downward trading market, prices tend to close near their low. Stochastics measures at what point the price of a security is within the entire price range of the security over a given period.

The stochastics indicator is plotted as two lines, %K and %D. The range of the Stochastics is between 0 and 100. With a price range of ten to twenty, ten would be given a 0 designation, fifteen would be at 50, and a price of twenty would be at the 100th percentile. The values of the stochastics calculations are dependent on the parameters given to %K and %D.

There are two types of stochastics: fast stochastics and slow stochastics. When calculating fast stochastics, the raw value of %K is the point at which the current price lies within the historical price range of its given period and the value of %D is the moving average of %K over a given number of periods.

When calculating slow stochastics, the value of %K slow is the %D-period moving average of the point at which the current price lies within the historical price range of its given period (or raw %K), and the value of %D slow is the moving average of the %K slow over a given number of periods. An oscillator refers to a momentum or rate-of-change indicator that is usually valued from -1 to +1 or 0% to %100.

Interpretation: There are several major interpretations for stochastics, which may be more beneficial when combined with other indicators that discern whether a market is in a trending or cyclical rotation mode.

One interpretation (and the one Dr. Lane believes to be most important) is to look for a divergence between %D and the price. An overbought market occurs when %D makes a series of lower highs while the price makes a series of higher highs. An oversold market occurs when the price makes a series of lower lows while %D makes a series of higher lows.

A second interpretation is to receive signals based on a crossover of the two lines. When the %K line rises above the %D line, it is considered bullish, and when the %K line falls below the %D line, it is considered bearish. You can eliminate some false signals by using only the signals which correspond to the direction of the intermediate- to long-term trends.

A third interpretation is that a buy signal is generated when either line dips below and then rises above 20 and a bearish signal is generated when either line rises above and then dips below 80. Many investors combine several of these interpretations as a major criterion used for making trading decisions.

By Bernard Stegmueller of Fusion Trading Zone

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