Stochastic oscillator 1

Stochastic oscillator
In technical analysis of securities trading, the stochastic oscillator is a momentum indicator that uses support and
resistance levels. Dr. George Lane promoted this indicator in the 1950s. The term stochastic refers to the location of
a current price in relation to its price range over a period of time.[1] This method attempts to predict price turning
points by comparing the closing price of a security to its price range.
The indicator is defined as follows:

where H and L are respectively the highest and the lowest price over the last periods, and

In working with %D it is important to remember that there is only one valid signal—a divergence between %D
and the analyzed security.[2]

Definition
The calculation above finds the range between an
asset’s high and low price during a given period of
time. The current securities price is then expressed as a
percentage of this range with 0% indicating the bottom
of the range and 100% indicating the upper limits of the
range over the time period covered. The idea behind
this indicator is that prices tend to close near the
extremes of the recent range before turning points. The
Stochastic oscillator is calculated:

Where
is the last closing price Stochastics Fast & Slow

is the lowest
price over the last N periods
is the highest price over the last N periods
is a 3-period exponential moving average of %K.
is a 3-period exponential moving average of %D.
A 3-line Stochastics will give an anticipatory signal in %K, a signal in the turnaround of %D at or before a bottom,
and a confirmation of the turnaround in %D-Slow.[3] Typical values for N are 5, 9, or 14 periods. Smoothing the
indicator over 3 periods is standard.
Dr. George Lane, a financial analyst, is one of the first to publish on the use of stochastic oscillators to forecast
prices. According to Lane, the Stochastics indicator is to be used with cycles, Elliot Wave Theory and Fibonacci
retracement for timing. In low margin, calendar futures spreads, one might use Wilders parabolic as a trailing stop
after a stochastics entry. A centerpiece of his teaching is the divergence and convergence of trendlines drawn on
stochastics, as diverging/converging to trendlines drawn on price cycles. Stochastics predicts tops and bottoms.
Stochastic oscillator 2

Interpretation
The signal to act is when there is a divergence-convergence, in an extreme area, with a crossover on the right hand
side, of a cycle bottom.[2] As plain crossovers can occur frequently, one typically waits for crossovers occurring
together with an extreme pullback, after a peak or trough in the %D line. If price volatility is high, an exponential
moving average of the %D indicator may be taken, which tends to smooth out rapid fluctuations in price.
Stochastics attempts to predict turning points by comparing the closing price of a security to its price range. Prices
tend to close near the extremes of the recent range just before turning points. In the case of an uptrend, prices tend to
make higher highs, and the settlement price usually tends to be in the upper end of that time period's trading range.
When the momentum starts to slow, the settlement prices will start to retreat from the upper boundaries of the range,
causing the stochastic indicator to turn down at or before the final price high.[4]
An alert or set-up is present when the %D line is in an
extreme area and diverging from the price action. The
actual signal takes place when the faster % K line
crosses the % D line.[5]
Divergence-convergence is an indication that the
momentum in the market is waning and a reversal may
be in the making. The chart below illustrates an
example of where a divergence in stochastics relative to
price forecasts a reversal in the price's direction.
Stochastic divergence.
An event known as "stochastic pop" occurs when prices
break out and keep going. This is interpreted as a signal
to increase the current position, or liquidate if the direction is against the current position.[6]

References
[1] Murphy, John J. (1999). " John Murphy's Ten Laws of Technical Trading (http:/ / stockcharts. com/ school/ doku.
php?id=chart_school:trading_strategies:john_murphy_s_ten_laws)".
[2] Lane, George M.D. (May/June 1984) “Lane’s Stochastics,” second issue of Technical Analysis of Stocks and Commodities magazine. pp
87-90.
[3] Lane, George C. & Caire (1998) "Getting Started With Stochastics" pg 3
[4] Person, John L (2004). A Complete Guide to Technical Trading Tactics: How to Profit Using Pivot Points, Candlesticks & Other Indicators.
Hoboken, NJ: Wiley. pp. 144–145. ISBN 0-471-58455-X.
[5] Murphy, John J (1999). Technical Analysis of the Financial Markets: A Comprehensive Guide to Trading Methods and Applications. New
York: New York Institute of Finance. p. 247. ISBN 0-7352-0066-1.
[6] Bernstein, Jake (1995). The Complete Day Trader. New York: McGraw Hill. ISBN 0-07-009251-6.

External links
• Stochastic Oscillator at Investopedia (http://www.investopedia.com/terms/s/stochasticoscillator.asp)
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