Overview

Sto.chas.tic (sto kas'tik) adj. 2. Math. designating a process 
having an infinite progression of jointly 
distributed random variables.
--- Webster's New World Dictionary

The Stochastic Oscillator compares where 
a security's price closed relative to its 
price range over a given time period.

Interpretation

The Stochastic Oscillator is displayed 
as two lines. The main line is called "%K." 
The second line, called "%D," is a 
moving average of %K. The %K line is 
usually displayed as a solid line and 
the %D line is usually displayed as 
a dotted line.

There are several ways to interpret 
a Stochastic Oscillator. Three popular methods include:

Buy when the Oscillator (either %K or %D) 
falls below a specific level (e.g., 20) and 
then rises above that level. Sell when 
the Oscillator rises above a specific level 
(e.g., 80) and then falls below that level.

Buy when the %K line rises above 
the %D line and sell when the %K line 
falls below the %D line.

Look for divergences. For example, 
where prices are making a series of new highs 
and the Stochastic Oscillator is failing to surpass 
its previous highs.

Calculation

The Stochastic Oscillator has four variables:

%K Periods.

This is the number of time periods 
used in the stochastic calculation.

%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.

%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.

%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:

Stoch_calc.jpg


For example, to calculate a 10-day %K, 
first find the security's highest-high and 
lowest-low over the last 10 days. 
As an example, let's assume that during 
the last 10 days the highest-high was 46 and 
the lowest-low was 38--a range of 8 points. 
If today's closing price was 41, 
%K would be calculated as:

Stochcalc1.jpg


The 37.5% in this example shows 
that today's close was at the level of 37.5% 
relative to the security's trading range over 
the last 10 days. If today's close was 42, 
the Stochastic Oscillator would be 50%. 
This would mean that that the security 
closed today at 50%, or the mid-point, 
of its 10-day trading range.

The above example used a 
%K Slowing Period of 1-day (no slowing). 
If you use a value greater than one, 
you average the highest-high and 
the lowest-low over the number of 
%K Slowing Periods before performing 
the division.

A moving average of %K is then 
calculated using the number of time 
periods specified in the %D Periods. 
This moving average is called %D.

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.