Stochastic Oscillator is one of the important tools used for technical analysis in securities trading. This technique was developed in late 1950s by Dr. George Lane. The indicator picks one observation point in current base and refers to all points in the defined range from where the highest and lowest point are considered for comparison. It helps to decide the current momentum when compared to the high & low of historic set in form of support and resistance levels. For this the consideration point is the price of the security in a term defined but it never follows the price pattern as it tracks the momentum or oscillation in the price movement. Dr. Lane stated the fact of rule “the momentum changes before the price moves to that direction” on the basis of which this tool was developed.
Stochastic compares the deviation or difference of current point with the highest and lowest point in a specified period and the formula used is explained below:
%K = 100*((C – L(N)) / (H(N) – L(N))
where,
%K is the derived indicator value
C is the current price point
L is the lowest price point over a specified period
H is the highest price point over a specified period
N is the defined period which can 5, 10, 14, 21 etc normally 14 is widely used period
By using this formula we can calculate different points of %K for a period of time in historic data set by dividing the data in different clusters e.g. 14 which can days, weeks, months etc. These points are then plotted on a graph as line chart. The %K value describes the level of current price in the look back high-low range considered, if its near 0% then that is termed as near bottom level and if it’s near 100% that is termed as near highest level. This indicator results can be quite abrupt due to its sensitivity to market movements, which can be minimized by averaging the price points. This means by taking moving average whether simple, exponential or weighted etc. which is 3-day moving average as explained below:
%D = (K1+K2+K3)/3
where,
%D is 3 day moving average of %K values
Usually a simple moving average is considered for above calculation. Average values derived are then plotted on graph along with %K line where we study the divergence between %D and %K of the security in question. Now evolved concept has been introduced in the study of stochastic oscillator which is Fast Stochastic Oscillator and Slow Stochastic Oscillator where Fast one is calculation of %K & %D and slow one is 3-day simple moving average of %D
%D-Slow = ((D1+D2+D3)/3)
This theory explains that current price will follow the price trend, if it’s on upward direction. Price will close near that or vice versa but stochastic will show the momentum or trend reversals in advance when %K crosses through 3-day %D or %D-Slow from bottom or top. The main points of stochastic oscillator are:
a) Calculation of %K where
– time periods – which the user can define, mostly used period is 14
– data set price, volume, returns where required points are current value, highest & lowest value in one time period
b) Calculation of %D where
– time period – which 3 day
– moving average of %K values
Example:
Take a default period 14-day for calculation %K
– In the first cluster, take price values of last 14 days excluding the current. From the cluster then pick highest price and lowest price points now calculate by using formula e.g. current price is 7950.50, highest value is 8055.00 and lowest is 7691.20 so
%K = 100*((7950.50-7691.20) / (8055.00-7691.20)) = 71.27 which shows it’s towards higher range
Likewise %K values are calculated for every cluster
Now calculate %D which 3-Day simple moving average of %K
– In the first cluster take first three %K values e.g.
%D = (72+71.27+70.73)/3 = 71.33
Similarly %D values are calculated for whole set
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