Stochastics Indicator

What is Stochastic Indicator?

A technical momentum indicator that compares a security's closing price to its price range over a given time period. The oscillator's sensitivity to market movements can be reduced by adjusting the time period or by taking a moving average of the result. 

The indicator consists of two lines:

• %K compares the latest closing price to the recent trading range.
• %D is a signal line calculated by smoothing %K.

Calculation

The Stochastic Oscillator has four variables:

1. %K Periods.
   This is the number of time periods used in the stochastic calculation.
    
2. %K Slowing Periods.
   This value controls the internal smoothing of %K. A value of 1 is considered a fast stochastic; a value of 3 is considered a slow stochastic.
    
3. %D Periods.
   This is the number of time periods used when calculating a moving average of %K. The moving average is called "%D" and is usually displayed as a dotted line on top of %K.
    
4. %D Method.
   The method (i.e., Exponential, Simple, Time Series, Triangular, Variable, or Weighted) that is used to calculate %D.
    

The formula for %K is:

The Stochastic Oscillator always ranges between 0% and 100%. A reading of 0% shows that the security's close was the lowest price that the security has traded during the preceding x-time periods. A reading of 100% shows that the security's close was the highest price that the security has traded during the preceding x-time periods.

Stochastic Theory

The theory behind this indicator is that in an upward-trending market, prices tend to close near their high, and during a downward-trending market, prices tend to close near their low. Transaction signals occur when the %K crosses through a three-period moving average called the "%D".

Types of Stochastic Indicators

Stochastics Fast

It uses shorter Time Periods, and Shorter Averages – this creates more fluctuations but conversely also more false alarms

The Stochastic Fast is charted using the following two lines.

Fast %K: [(Close - Low) / (High - Low)] x 100 (shown as black line above)
Fast %D: Simple moving average of Fast K (3-day MA) (shown as blue “trigger line” above)

Stochastics Slow

It uses longer time periods and longer average periods – this creates a smoother flow and gives the ability to see trends clearer, the drawback is the Indicator lags price and is less responsive.

The Stochastic Slow is charted using the following two lines. 

Slow %K: Equal to Fast %D (3-day MA of Fast %K) (shown as black line above)
Slow %D: Simple moving average of Slow %K (shown as blue “trigger line” above)

Which is better? Well, the Stochastics Slow is usually preferred by most traders because is does not show as many false buy and sell signals.

Conclusion

The stochastics indicator is for the most part a range pattern indicator. It is used to determine overbought/oversold levels in a manner similar to the RSI. The oversold level is at 20, while the overbought level resides at 80. Although this is the most basic way of using this indicator, it is in fact rarely used because of the tendency to create false signals. Instead, as with most other oscilators, convergence/divergence patterns are sought between the price and the indicator, and then trading decisions are made sometimes supported by secondary concepts like the price extremes, or crossovers that can sometimes signal momentum changes.

Both for the fast and slow stochastics indicators, indicator crossovers are used to create trade signals on the basis of the movement of the %K component. The %K component is the faster moving of the two components, and when it rises above, or falls below the slower %D, a buy or sell signal will be generated.


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