Stochastic
Tue, Apr 15The Stochastic Oscillator is a momentum indicator that indicates the position of the closing price in relation to the high-low range over a specified number of periods. Developed by George C. Lane in the late 1950s, it was based on the belief that momentum shifts occur before price changes, leading to the creation of the Stochastic Oscillator to track the "speed" or momentum of price movements.
This oscillator operates on the premise that during an uptrend, the closing price will typically be equal to or above the previous period’s closing price, while in a downtrend, prices will generally be equal to or below the previous closing price.
In summary:
- In an uptrend, the closing price usually ends near the high.
- In a downtrend, the closing price typically ends near the low.
If the closing price begins to move away from the high or the low, it suggests that momentum is waning. Stochastics are particularly effective in wide trading ranges or slow-moving trends.
The indicator ranges from 0 to 100. It features two lines: the fast oscillating %K and a moving average of %K, commonly known as %D. The Stochastic Oscillator assesses the closing level relative to the high-low range over a specified time frame.
For example, if the highest high is 100, the lowest low is 90, and the close is 98, the high-low range is 10 (100-90), which serves as the denominator in the %K formula. The difference between the close and the lowest low equals 8, which is the numerator. Dividing 8 by 10 results in 0.80 or 80%. Multiplying this by 100 gives %K. If the close were at 92, %K would equal 20 (0.20 x 100).
The Stochastic Oscillator is above 50 when the close is in the upper half of the range and below 50 when it is in the lower half. Low readings (below 20) suggest that the price is near its LOW for the specified time period, while high readings (above 80) indicate that the price is near its HIGH for that period.
Overbought/Oversold Conditions
The levels of 80 and 20 are the most commonly used. Generally, values above 80 indicate an overbought condition, while values below 20 suggest an oversold condition. A sell signal is generated when the oscillator is above 80 and then crosses back below it. Conversely, a buy signal occurs when the oscillator is below 20 and then crosses back above it.
Crossover Signal
A crossover signal arises when the two lines intersect in the overbought or oversold regions. A sell signal is triggered when a declining %K line crosses below the %D line in the overbought area. A buy signal is indicated when an increasing %K line crosses above the %D line in the oversold area.
Divergences
Divergences occur when the price reaches a new high or low, but the Stochastic Oscillator does not. A bullish divergence happens when the price makes a lower low while the Stochastic Oscillator forms a higher low, signaling reduced downward momentum and a potential bullish reversal. Conversely, a bearish divergence occurs when the price makes a higher high, but the Stochastic Oscillator creates a lower high, indicating diminished upward momentum and a potential bearish reversal.
There are three versions of the Stochastic Oscillator: Fast, Slow, and Full. Each version utilizes a different calculation method for the basic Stochastic Oscillator value.
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