Stochastic

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Introduction

The Stochastic is a momentum oscillator similar to the RSI.  It's a leading indicator, meaning momentum changes direction before price - this is a general technical analysis rule.  Both the RSI and Stochastic can be used in tandem or separately to confirm overbought and oversold signals by measuring the stocks rate of change in price. For the purpose of realizing when a stock has moved into an overbought or oversold position, stochastics is the favored technical indicator as it is easy to perceive and has a high degree of accuracy. The stochastic works best in a ranging market, but it can be used to great effect in trending markets, so like the RSI it’s good for confirming trend and trading price consolidations

The Theory and Interpretation

George Lane invented the indicator to indicate overbought and oversold positions. Very simply the stochastic looks at the financial mechanisms closing price in relation to its trading position in a given number of periods. Price action is the price the security traded throughout the day. A market that constantly closes in the upper end of its trading range is going to have a high reading and be trending up and vice-versa. It is calculated as below:

%K = 100{(most recent closing price - Low of the previous 14 sessions)/(High of the previous 14 sessions – Low of the previous 14 sessions)} 
%D = Simple moving average of %K (This is usually 3 or 5 periods)

As we've mentioned the stochastic looks at the financial markets closing price in relation to its trading position for a given number of periods. In the “stochastic Interpretation” chart below we have a daily chart showing the closing positions for the last 14 trading days (periods). As you can see, our current OHLC bar closed at 1.09480, which was the highest it has closed in 14 trading periods. Hence the stochastic oscillator is sitting high at 92.9702. This indicates the market is over bought.  We can also chart intra-day trading periods, weeks, months etc... The workings are the same.

Interpreting the Stochastic

Reading The Chart

As seen in the below chart, the stochastic is drawn in a box below the price of the security with a %K line and a %D line. These lines are banded against a scale of 0 to 100 with the overbought and oversold indicator bands at 80 and 20 respectively. A K result of 80 means that the markets current price closed above 80% of all prior closing prices within the period measured - in this case 14.  The opposite occurs when the Stochastic drops below the 20 mark. Investors need to consider selling the stock when the indicator moves above the 80 level. Conversely, the investor needs to consider buying an issue that is below the 20 line and is starting to move above the 20 line with increased volume. Today's charting software does all the calculations for you, making the whole technical analysis process so much easier and thus more exciting for the average investor. 

The Stochastic

When the K line is increasing then momentum in the market is increasing and when K line is falling this is an indication that momentum in the market is decreasing. We can see this in the above chart.  The D line is usually a 3-day or sometimes 5-day simple moving average of the K line (in our eg. it's 3 day), acting as a signal line for trades when the two cross. The stochastic oscillator generally uses the past 14 periods when making it’s calculations, but this can be adjusted depending on the trading strategy. The 14 periods can be intra-day, days, weeks, months and years – depending on the chart you’re looking at. The %D moving average can also be adjusted.

Changing the Stochastic Parameters - Full, Slow and Fast

There are 3 different types of Stochastic Oscillator - The ‘Fast’, The ‘Slow’ and The ‘Full’ stochastic. The fast stochastic is the raw data George Lane version and is extremely sensitive, so churns out many signals as shown at the bottom of the below chart. It is accompanied by a 3-period (or 5-period) SMA signal called %D.  In our examples we're using a 14 period K, but other periods can be used.  It's called "fast" because the look back period doesn't have a smoothing device, so any look back period (5, 10, 20, etc...) can be classified as "fast".

Fast Stochastic Oscillator:
  • Fast %K = %K basic calculation
  • Fast %D = 3-period SMA of Fast %K

The slow stochastic smooths the oscillator with a 3-day SMA of K and is also accompanied by a 3-day SMA %D, so %D is now a SMA of K and it's 3-period SMA.  The result of this smoothing is shown at the top of the below chart.  You can see this results in less buy and sell signals, but they are now more robust.  The 3 period SMA of K can be increased - sometimes you'll see a 5 period SMA.  Any kind of smoothing action on the %K will result in a "slow" stochastic.

Slow Stochastic Oscillator:
  • Slow %K = Fast %K smoothed with 3-period SMA
  • Slow %D = 3-period SMA of Slow %K
The Full Stochastic is a fully customisable stochastic. In this customisation all the parameters and SMA's (simple moving averages) can be changed.  Many charting packages will allow you to change these parameters.  A full stochastic of (%K 14, 1), (%D 3) is equivalent to a fast stochastic - there is no smoothing of K as the SMA is set to 1.  A full stochastic of (%K 14,3), (%D 3) is equivalent to a slow stochastic, as there is a 3-period SMA smoothing mechanism.  Both of these slow and fast stochastic are represented below by the customisable full stochastic.

Slow and Fast Stochastic - A comparison

The parameters can be further changed.  For instance If looking at a weekly chart the full stochastic can be changed to (%K20,5) (%D5) - This is a slow stochastic measuring momentum over the last 20-periods with a smoothing 5-period %K and a 5-period trigger (%D).  In fact any stochastic that doesn't smooth with a K SMA is a fast stochastic and any stochastic that does smooth is a slow stochastic.

Whatever stochastic a trader uses they all operate in a similar manner.  Generally traders refer to "The Stochastic" and usually talk about the slow stochastic - this will be our focus. There are 3 main ways to trade the stochastic, which we’ll go onto talk about in Stochastic (ii):
  • Overbought and Oversold Signals 
  • Crossover Signals 
  • The Stochastic Divergence
More...


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Introduction

The Stochastic is a momentum oscillator similar to the RSI.  It's a leading indicator, meaning momentum changes direction before price - this is a general technical analysis rule.  Both the RSI and Stochastic can be used in tandem or separately to confirm overbought and oversold signals by measuring the stocks rate of change in price. For the purpose of realizing when a stock has moved into an overbought or oversold position, stochastics is the favored technical indicator as it is easy to perceive and has a high degree of accuracy. The stochastic works best in a ranging market, but it can be used to great effect in trending markets, so like the RSI it’s good for confirming trend and trading price consolidations

The Theory and Interpretation

George Lane invented the indicator to indicate overbought and oversold positions. Very simply the stochastic looks at the financial mechanisms closing price in relation to its trading position in a given number of periods. Price action is the price the security traded throughout the day. A market that constantly closes in the upper end of its trading range is going to have a high reading and be trending up and vice-versa. It is calculated as below:

%K = 100{(most recent closing price - Low of the previous 14 sessions)/(High of the previous 14 sessions – Low of the previous 14 sessions)} 
%D = Simple moving average of %K (This is usually 3 or 5 periods)

As we've mentioned the stochastic looks at the financial markets closing price in relation to its trading position for a given number of periods. In the “stochastic Interpretation” chart below we have a daily chart showing the closing positions for the last 14 trading days (periods). As you can see, our current OHLC bar closed at 1.09480, which was the highest it has closed in 14 trading periods. Hence the stochastic oscillator is sitting high at 92.9702. This indicates the market is over bought.  We can also chart intra-day trading periods, weeks, months etc... The workings are the same.

Interpreting the Stochastic

Reading The Chart

As seen in the below chart, the stochastic is drawn in a box below the price of the security with a %K line and a %D line. These lines are banded against a scale of 0 to 100 with the overbought and oversold indicator bands at 80 and 20 respectively. A K result of 80 means that the markets current price closed above 80% of all prior closing prices within the period measured - in this case 14.  The opposite occurs when the Stochastic drops below the 20 mark. Investors need to consider selling the stock when the indicator moves above the 80 level. Conversely, the investor needs to consider buying an issue that is below the 20 line and is starting to move above the 20 line with increased volume. Today's charting software does all the calculations for you, making the whole technical analysis process so much easier and thus more exciting for the average investor. 

The Stochastic

When the K line is increasing then momentum in the market is increasing and when K line is falling this is an indication that momentum in the market is decreasing. We can see this in the above chart.  The D line is usually a 3-day or sometimes 5-day simple moving average of the K line (in our eg. it's 3 day), acting as a signal line for trades when the two cross. The stochastic oscillator generally uses the past 14 periods when making it’s calculations, but this can be adjusted depending on the trading strategy. The 14 periods can be intra-day, days, weeks, months and years – depending on the chart you’re looking at. The %D moving average can also be adjusted.

Changing the Stochastic Parameters - Full, Slow and Fast

There are 3 different types of Stochastic Oscillator - The ‘Fast’, The ‘Slow’ and The ‘Full’ stochastic. The fast stochastic is the raw data George Lane version and is extremely sensitive, so churns out many signals as shown at the bottom of the below chart. It is accompanied by a 3-period (or 5-period) SMA signal called %D.  In our examples we're using a 14 period K, but other periods can be used.  It's called "fast" because the look back period doesn't have a smoothing device, so any look back period (5, 10, 20, etc...) can be classified as "fast".

Fast Stochastic Oscillator:
  • Fast %K = %K basic calculation
  • Fast %D = 3-period SMA of Fast %K

The slow stochastic smooths the oscillator with a 3-day SMA of K and is also accompanied by a 3-day SMA %D, so %D is now a SMA of K and it's 3-period SMA.  The result of this smoothing is shown at the top of the below chart.  You can see this results in less buy and sell signals, but they are now more robust.  The 3 period SMA of K can be increased - sometimes you'll see a 5 period SMA.  Any kind of smoothing action on the %K will result in a "slow" stochastic.

Slow Stochastic Oscillator:
  • Slow %K = Fast %K smoothed with 3-period SMA
  • Slow %D = 3-period SMA of Slow %K
The Full Stochastic is a fully customisable stochastic. In this customisation all the parameters and SMA's (simple moving averages) can be changed.  Many charting packages will allow you to change these parameters.  A full stochastic of (%K 14, 1), (%D 3) is equivalent to a fast stochastic - there is no smoothing of K as the SMA is set to 1.  A full stochastic of (%K 14,3), (%D 3) is equivalent to a slow stochastic, as there is a 3-period SMA smoothing mechanism.  Both of these slow and fast stochastic are represented below by the customisable full stochastic.

Slow and Fast Stochastic - A comparison

The parameters can be further changed.  For instance If looking at a weekly chart the full stochastic can be changed to (%K20,5) (%D5) - This is a slow stochastic measuring momentum over the last 20-periods with a smoothing 5-period %K and a 5-period trigger (%D).  In fact any stochastic that doesn't smooth with a K SMA is a fast stochastic and any stochastic that does smooth is a slow stochastic.

Whatever stochastic a trader uses they all operate in a similar manner.  Generally traders refer to "The Stochastic" and usually talk about the slow stochastic - this will be our focus. There are 3 main ways to trade the stochastic, which we’ll go onto talk about in Stochastic (ii):
  • Overbought and Oversold Signals 
  • Crossover Signals 
  • The Stochastic Divergence
More...


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Subpages (1): Stochastic (ii)
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