The stochastic oscillator compares a stock’s closing price to its high
and low prices for a particular period. The assumption is that as stocks
trend upward, the closing prices end on the high side for the specified
period. Conversely, as stocks trade downward, they tend to close towards
their low price for that specified period.
The stochastic indicator is charted on a regular vertical/horizontal
chart. The scale of the vertical axis is measured from 0 to 100, while the
horizontal axis reflects the time periods.
The stochastic indicator has two trendlines, as follows:
- %K – is a comparison, expressed as a percent, of the stock’s closing
price to its high and low for a specified time period. % K is considered
the fast line.
- %D – is a 3 period (usually days) moving average of the % K trendline.
%D is considered the slow line.
It is extremely important to understand the calculation of the %K trendline. The formula is below:
%K = [(C-LP) / (HP – LP)] * 100
%K = [(Closing Price – Low Price (N)) / (High Price (N) –
Low Price (N))] * 100
N = Number of periods
For example, if a stock closed at $10 and had a high of $11 and a low of
$8 for a day, its % K chart point would be calculated as follows:
%K = [($10 - $8) / ($11 - $8)] * 100
%K = 66.67
Fast vs. slow stochastic: when plotting the %K and %D lines, %K often
crossed over %D, causing analysts to misread the ultimate direction of the
fast trendline. This resulted in a newer slow calculation of the %K that
smoothed the results, making them easier to interpret. Instead of using the
raw values of %K, the slow stochastic uses the 3-day moving average of the
raw data. Then, %D is re-calculated based on the new % K values. The fast
stochastic uses the raw data to produce the %K trendline, while the slow
stochastic uses a 3-day moving average of the raw data. %D is always the
3-day moving average of %K.
Below is a diagram of the fast and slow stochastic indicators, using
Verizon as the subject. Verizon is an interesting stock play; you have to
wonder if the growth in its wireless division can offset the decline in
landlines and the inroads of the cable companies. The risk seems to be
already factored into the stock; its current shareholders should do well.
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The main objectives in using the stochastic oscillators are listed below:
- To identify overbought and oversold securities. It is believed that
when the indicators rise above 80 a stock is probably overbought, while if
the indicators are below 20 the stock may be oversold.
- To identify trend reversals and buy and sell signals. When the %K
line crosses over and raises above the %D line, a buy signal is
generated. Conversely, a sell signal is generated when the %K trendline
crosses over and falls below the %D line.
- To identify divergences between the actual stock prices and the
oscillators. This often indicates that a reversal back to the normal
trendline is in order.
A buy signal is generated when the stochastic indicators fall below the
20 level, then reverse and rise above it. Conversely, a sell signal is
generated as the stochastic indicators rise above 80 then fall below that
It is also important to understand the signal that the trend is
generating. One should be very cautious if you have a security in an
overbought reading, or shorting a security in an oversold market. Momentum
investors, however, specialize in buying with the trend.
Don’t necessarily sell a security in an overbought range. This is where
profits are made. A stock can stay in an overbought range for a long time.
Stay with the trend until a reversal signal is determined.
There is also a third version of the stochastic indicator called the full
stochastic. The full stochastic is a more advanced version of the fast and
slow stochastic, using different time frame scenarios.
The stochastic approach of using two trendlines to predict future price
movements based on a stock’s historical high, low, and closing prices was
innovative, and is now a proven stock timing technique that can be of value
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