STOCHASTIC OSCILLATOR
OVERVIEW
Stochastic (sto kas' tik) adj. . . . 2. Math. designating a process having an infinite progression of jointly
distributed random variables. -Webster's New World Dictionary
The Stochastic Oscillator compares where a security's price dosed relative to its price range over a given
time period.
INTERPRETATION
The Stochastic Oscillator is displayed as two lines. The main line is called %K. The second line, called
%D, is a moving average of %K. The %K line is usually displayed as a solid line, and the %D line is
usually displayed as a dotted line.
There are several ways to interpret a Stochastic Oscillator. Three popular methods include:
1. Buy when the Oscillator (either %K or %D) falls below a specific level (e.g., 20) and then ri ses
above that level. Sell when the Oscillator rises above a specific level (e.g., 80) and then falls
below that level.
2.
Buy when the %K line rises above the %D line and sell when the %K line falls below the %D
line.
3.
Look for divergences (see page 35), for example, where prices are making a series of new highs
and the Stochastic Oscillator is failing to surpass its previous highs.
EXAMPLE
The following chart shows California Energy and its 10-day Stochastic. I drew "buy' arrows when the
%K line fell below, and then rose above, the level of 20. Similarly, I drew "sell" arrows when the %K
line rose above, and then fell below, the level of 80.
This next chart also shows California Energy. In this example I drew "buy" arrows each time the
%K line rose above the %D (dotted). Similarly, "sell" arrows were drawn when the %K line fell
below the %D line.
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STOCHASTIC OSCIL 1 ATOR
This final chart shows a divergence between the Stochastic Oscillator and prices. This is a classic
divergence where prices are headed higher but the underlying indicator (the Stochastic Oscillator) is
moving lower. When a divergence occurs between an indicator and prices, the indicator typically
provides the clue as to where prices will head.
CALCULATION
The Stochastic Oscillator has four variables:
%K Periods. This is the number of time periods used in the stochastic calculation.
3.
%K Slowing Periods. This value controls the internal smoothing of %K A value of 1 is considered a
fast stochastic; a value of 3 is considered a slow stochastic.
%D Periods. This is the number of time periods used when calculating a moving average of %K The
moving average is called %D and is usually displayed as a dotted line on top of %K
4. %D Method. The method (i.e., Exponential, Simple, Time Series, Triangular, Variable, or
Weighted) that is used to calculate %D.
The formula for %K is:
Today's Close - Lowest Low in %K Periods
* 100 Highest High in %K Periods - Lowest
Low in %K Periods
For example, to calculate a 10-day %K, first find the security's highest-high and lowest-low over the
last 10 days. As an example, let's assume that during the last 10 days the highest-high was 46 and the
lowest-low was 38-a range of 8 points. If todays closing price was 41, %K would be calculated as:
37.5 =
41 -38 ) * 100 4G-38
The 37.5 percent in this example shows that todays close was at the level of 37.5 percent relative to the
security's trading range over the last 10 days. If todays dose was 42, the Stochastic Oscillator would be
50 percent. This would mean that the security closed today at 50 percent, or the midpoint, of its 10-day
trading range.
The above example used a %K Slowing Period of 1 day (no slowing). If you use a value greater than 1,
you average the highest-high and the lowest-low over the number of %K Slowing Periods before
performing the division.
A moving average of %K is then calculated using the number of time periods specified in the %D
Periods. This moving average is called %D.
The Stochastic Oscillator always ranges between 0 percent and 100 percent. A reading of 0 percent
shows that the security's close was the lowest price that the security has traded during the preceding
x time periods. A reading of 100 percent shows that the security's close was the highest price that
the security has traded during the preceding x time periods.