Stochastics

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The Stochastics indicator was introduced by George C. Lane in the late1950s. In technical analysis this oscillator is a momentum indicator that compares an equities current close to its high/low range over a set number of periods.

Stochastics is calculated according to the following formula:

Raw Stochastics(n) = 100 * (Recent Close - Lowest Low) / (Highest High - Lowest Low);

%K = 3-period moving average of Raw Stochastics;

%D = 3-periods moving average of %K;

n = number of periods used in the calculation to define highest high and lowest low.

Because it is a percentage or ratio, %K will fluctuate between 0 and 100. A 3-day simple moving average of %K is usually plotted alongside %D to act as a signal or trigger line.

Stochastics shows how far the most recent close is away from the lowest low and highest high (over the calculated period):

• A security is close to a 20-day high if its 20-day Stochastics is greater than 80%;
• A security is close to a 20-day low if its 20-day Stochastics is below 20%.

We can differentiate three types of stochastic oscillators: Fast, Slow, and Full.

%K and %D make up the Fast stochastic oscillator. The driving force behind both stochastic oscillators is %K (fast), which can be calculated with the formula provided above.

A 3-day simple moving average applied to the %K Fast Stochastics calculates the Slow Stochastics. %D (Fast) is identical to %K (Slow). An X-day simple moving average applied to the %K Fast Stochastics calculates Slow Stochastics.

Stochastics readings above 80 are typically considered to indicate an overbought situation whereas Stochastics readings below 20 are generally thought to indicate an oversold situation; however, a reading below 20 is not necessarily bullish nor is a reading above 80 automatically a bearish sign. A stock may continue to rise after its Stochastics has reached 80; conversely; it may continue to fall even after its Stochastics has reached 20. The probability of a reversal is much higher when volume surges occur close to index highs or lows (as indicated by the Stochastics).

• As a general rule, volume surges (indicated by a high PVO) that appear during a price advance when combined with closes near the highs (i.e., Stochastics > 80%) indicate potential downside reversals;
• As a general rule, volume surges (indicated by a high PVO) that appear during a price decline when combined with closes near the lows (i.e., Stochastics < 20%) indicate potential upside reversals.
• Ignore volume surges that appear when Stochastics readings exceed 20% and are below 80%. Market reactions might be short-lived under these circumstances.

Chart 1:S&P 500 Index (^SPX) - Stochastics Fast and Slow

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