The stochastic oscillator is a momentum indicator used in
technical analysis, introduced by George Lane in the 1950s, to
compare the closing price of a commodity to its price range
over a given time span.
The idea behind this indicator is the prices tend to close
near their past highs in bull markets, and near their lows in
bear markets. Transaction signals can be spotted when the
stochastic oscillator crosses its moving average.
Two stochastic oscillator indicators are typically calculated
to assess future variations in prices, a fast (%K) and slow
(%D). Comparisons of these statistics are a good indicator of
speed at which prices are changing or the Impulse of Price. %K
is the same as Williams %R, though on a scale 0 to 100 instead
of -100 to 0, but the terminology for the two are kept
separate.
The fast stochastic oscillator or Stoch %K calculates the
ratio of two closing price statistics: the difference between
the latest closing price and the lowest closing price in the
last N days over the difference between the highest and lowest
closing prices in the last N days.
The usual "N" is 14 days but this can be varied. When the
current closing price is the low for the last N-days, the %K
value is 0, when the current closing price is a high for the
last N-days, %K=100.
The %K and %D oscillators range from 0 to 100 and are often
visualized using a line plot. Levels near the extremes 100 and
0, for either %K or %D, indicate strength or weakness
(respectively) because prices have made or are near new N-day
highs or lows.
There are two well known methods for using the %K and %D
indicators to make decisions about when to buy or sell stocks.
The first involves crossing of %K and %D signals, the second
involves basing buy and sell decisions on the assumption that
%K and %D oscillate.
In the first case, %D acts as a trigger or signal line for %K.
A buy signal is given when %K crosses up through %D, or a sell
signal when it crosses down through %D. Such crossovers can
occur too often, and to avoid repeated whipsaws one can wait
for crossovers occurring together with an overbought/oversold
pullback, or only after a peak or trough in the %D line. If
price volatility is high, a simple moving average of the Stoch
%D indicator may be taken. This statistic smooths out rapid
fluctuations in price.
In the second case, some analysts argue that %K or %D levels
above 80 and below 20 can be interpreted as overbought or
oversold. On the theory that the prices oscillate, many
analysts including George Lane, recommend that buying and
selling be timed to the return back from these thresholds. In
other words, one should buy or sell after a bit of a reversal.
Practically, this means that once the price exceeds one of
these thresholds, the investor should wait for prices to
return back through those thresholds (e.g. if the oscillator
were to go above 80, the investor waits until it falls below
80 to sell).
George Lane, a financial analyst from the 1950s is one of the
first to publish on the use of stochastic oscillators to
forecast prices. According to Lane you use the stochastics
indicator with a good knowledge of "Elliot Wave Theory". A
centre-piece of his teaching is the divergence and convergence
of trend lines drawn on stochastics as diverging/ converging
to trend lines drawn on price cycles. Stochastics has the
power to predict tops and bottoms.
It should be noted that the existence of price oscillations is
hypothetical and statistical at best--stock price movements
are a consequence of the actions of human decision-makers and
past behaviour of market variables does not necessarily
predict future behaviour. |
