In technical analysis of securities trading, the stochastics oscillator is a momentum indicator that uses support and resistance levels. Dr. George Lane promoted this indicator in the 1950s. The term stochastic refers to the location of a current price in relation to its price range over a period of time. This method attempts to predict price turning points by comparing the closing price of a security to its price range.
The indicator is defined as follows:
where H and L are respectively the highest and the lowest price over the last periods, and
In working with %D it is important to remember that there is only one valid signal—a divergence between %D
and the security with which you are working.
The calculation above finds the range between an asset’s high and low price during a given period of time. The current securities price is then expressed as a percentage of this range with 0% indicating the bottom of the range and 100% indicating the upper limits of the range over the time period covered. The idea behind this indicator is that prices tend to close near the extremes of the recent range before turning points. The Stochastic oscillator is calculated:
Where is the last closing price LOWn(Price) is the lowest price over the last N periods HIGHn(Price) is the highest price over the last N periods
EMA3(%D) is a 3-period exponential moving average of %K.
EMA3(%D)-Slow) is a 3-period exponential moving average of %D.
A 3-line Stochastics will give you an anticipatory signal in %K, a signal in the turnaround of %D at or before a bottom, and a confirmation of the turnaround in %D-Slow. Typical values for N are 5, 9, or 14 periods. Smoothing the indicator over 3 periods is standard.
Dr. George Lane, a financial analyst, is one of the first to publish on the use of stochastic oscillators to forecast prices. According to Lane, the Stochastics indicator is to be used with cycles, Elliot Wave Theory and Fibonacci retracement for timing. In low margin, calendar futures spreads, you might use Wilders parabolic as a trailing stop after a stochastics entry. A centerpiece of his teaching is the divergence and convergence of trendlines drawn on stochastics, as diverging/converging to trendlines drawn on price cycles. Stochastics predicts tops and bottoms.
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