Stochastic Oscillator (SO)
A momentum indicator that uses support and resistance levels
Dr. George Lane promoted this indicator in the 1950s. “Stochastic” refers to the location of a current price in relation to its price range over a period of time. This method attempts to predict price turning points by comparing the closing price of a security to its price range.
The indicator is calculated as:
%K = 100 closing price – price low / price high – price low
Stochastics can be controlled by altering the period considered for the highs and lows. In working with %D it is important to remember that there is only ONE valid signal. That signal is a divergence between %D and the security with which you are working.
The calculation above looks for the range between the high and low price of an asset during a time period. The current securities price is then expressed as a percentage of this range with 0% as the lower limit and 100% as the range’s upper limit over the time period covered. The idea behind this indicator is that prices tend to close near the extremes of the recent range before turning points. The Stochastic oscillator is calculated:
Where Price is the last closing price,
LOW N(Price) is the lowest price over the last N periods
HIGH N(Price) is the highest price over the last N periods
EMA3(%D) is a 3-period exponential moving average of %K.
EMA3(%D − Slow) is a 3-period exponential moving average of %D.
A 3-line Stochastics will give you an anticipatory signal in %K, a signal in the turnaround of %D at or before a bottom, and a confirmation of the turnaround in %D-Slow. For N the typical values are 5, 9, or 14 periods. It is standard to smooth the indicator over 3 periods.
The signal to act is when you have the following,
(a) divergence – convergence,
(b) must occur in an extreme area, and
(c) a crossover on the right hand side, of a cycle bottom.
It is possible for Plain crossovers to occur too often. To avoid these repeated whipsaws, it is advisable to wait for crossovers occurring together with an extreme pullback, after a peak or trough in the %D line. An exponential moving average of the Stoch %D indicator may be taken if the price volatility is high. This statistic smooths out rapid fluctuations in price.
A number of analysts argue that %K or %D levels above 80 and below 20 can be interpreted as extreme areas. On the theory that the prices go up and down, a lot of analysts including Dr. Lane, advise that buying and selling be timed to the return from these thresholds. Simply put, one should buy or sell only after a little reversal. This means that once the price exceeds one of these thresholds, the investor should wait until the prices return to those thresholds.
Divergence – convergence is an indication that the momentum in the market is losing steam and a reversal may occur.