What is the Stochastic Oscillator?
The Stochastic Oscillator is made up of two moving curves, the slow %D line and the fast %K line. Similar to moving averages and the MACD indicator, the stochastics show buy and sell signals based on the crossing of the lines.
There are four variables that make up the oscillator.
- The number of time periods used in the stochastic calculation which are called the %K periods.
- The number of time periods used in the calculation of the moving average of %K are called the %D periods.
- The value that controls the speed of the interior smoothing of %K.
- The %D method used to help measure %D: Simple, Exponential, Time Series, Weighted, or Variable Triangular.
The following calculations use 14 and 3 as the number settings, however, your charting package should allow you to set your preferred settings.
How %K is Calculated: %K = 100[(C - L14)/(H14 - L14)]
Where C is the most recent closing price, L is the low if the 14 previous trading periods and H is the high of the 14 previous trading periods.
How %D is Calculated: A 3-period moving average of %K.
Interpretation of the stochastics is based on the idea that a stock’s closing price tends to trade at the high end of the day’s price action for days that close up. For days that price closes down, a stock’s closing price tends to trade at the low end of the day’s price action.
How to Use the Stochastics to Trade
The %K line is the fast line and the %D line is the slow line. When the %K line crosses above the %D line, that is a buy signal. When the %K line crosses below the %D line, that is a sell signal. When either line crosses above 80 and falls back below, that signals that the stock is overbought and triggers a sell signal. Likewise, when either line crosses below 20 and rises back up, that signals that the stock is oversold and triggers a buy signal.
Scalpers tend to use the Stochastic Oscillator because of it’s quickness to follow the price action.
The stochastics can also be used to spot a hidden divergence if the price makes higher highs but the indicator fails to do the same.
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