Stochastic Oscillator Indicator

Stochastics Oscillator Indicator, like any technical indicator, can be a useful tool in implementing your trading strategy as long as you understand both its strengths and weaknesses. Stochastics work best with those securities that are in a trading range or are non-trending. Under these conditions, the stochastic indicator may prove useful in identifying buying and selling points based on divergences between the indicator and the security's price, the interaction

between the %K and %D lines that make up the oscillator, as well as when a security may be overbought or oversold. But stochastics can return false signals, especially during strong up- and downtrends. Using stochastics with other indicators can help reduce the risk of entering a trade against the overall trend.

Stochastic Oscillator: THE CALCULATION

The word stochastic is defined in general as a process involving a random variable. The stochastic oscillator was first introduced by George Lane in the 1970s. This indicator consists of two lines-the %K and %D lines-and compares the most recent closing price of a security to the price range in which it traded over a specified time period. The following formula shows you how to calculate the latest point on the %K line:
%K = [(Close − Lo) / (Hi − Lo)] * 100
Where: Close = Last closing price Hi = Highest intraday price over the designated period Lo = Lowest intraday price over the designated period Therefore, if you were calculating a five-day %K line, the first point would be calculated using the highest price over the last five trading days and the lowest price over the last five trading days as well as the closing price for day five (the last day of the five-day period).

The %D line typically is a three-point moving average of the %K line, and serves as a "trigger" line for generating trading signals. In other words, you add together the last three %K values, divide this sum by three, and continue this over a rolling three-day period. You can use any type of moving average you wish when calculating the %D line, including simple, weighted, or exponential moving averages. Like virtually all technical indicators, you can calculate stochastics over any time period you wish, depending on your trading style. The shorter the time period used to establish the high-low comparison, the more responsive the indicator is to price changes which, in turn, will increase the number of signals the indicator generates. Alternatively, as you increase the time period used in calculating an indicator, you increase the time in which it takes to respond to current price movements. This lowers the number of signals the indicator generates. Also, keep in mind that you can use any time increment as well-minute, hour, day, week, month, etc. The same principles apply no matter the time period or increment you use.