Table of contents

Stochastic

Last modified 12:51, 28 Sep 2012
Table of contents

Stochastic

The Stochastic Indicator is part of the Oscillator Group and measures the relative position of the closing price within a past high-low range.

It is based on the observation that closing prices tend to be closer to the interval's highest price as an upward move gains strength. The reverse holds as a decline gathers strength. closing prices often remain just above the lows as the decline gains strength. By definition, a stochastic is a guess. It’s something random that defies prediction.

Developed by George C Lane, it is a very popular indicator having two lines (%K, an oscillator, and %D, a moving average of %K) displayed in a range of 1-100.

The formula for %K produces a line that measures, on a scale of 1 to100, where the current closing price is in relation to the total price range for the selected time period (14 intervals is the default period):

stochformula.png

The %D line is simply a moving average that smoothes the appearance of the %K line. The intervals used in the average can be set by the user, its default is 3 intervals. The slower moving %D line provides more reliable signals, and is normally the line relied upon by traders.

There are two lines in a stochastic, a fast line and a slow line. Signals are provided when they cross. The fast line is called %K. The formula behind %K is quite simple.

For example, assume a stock has traded between $1.80 and $2.20 over the previous 5 days. (It does not matter whether it rose, fell or meandered between-all we need is the total trading range.) If it closed today at $2.20, it would yield a %K value of 100%. If it closed at $1.80, %K would equal 0%. A close at the midpoint, $2.00, provide a %K value of 50%.

The %D slow line is usually a three-day moving average of %K, generating the following signals:

  • Buy %K crosses above %D, especially when both are below a level of 25.
  • Sell %K crosses below %D, especially when both are above a level of 75.

There are many different interpretations of this indicator, but perhaps one of the most valuable guides is to pay heed to the bullish signals in a bullish market and conversely bearish signals in a bearish market. There are some variations of this indicator with the more common variation called slow stochastics. This indicator is also enhanced when used as a filter or in conjunction with other indicators.

The stochastic generates a large number of false signals. However, you should be able to thresh the correct signals from the false ones by combining it with the other indicators available within Your SOFTWARE.

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