Stochastic Oscillator

Stochastic oscillator is one of the main momentum indicators used by traders in Forex technical analysis. Introduced by George C. Lane in the late 1950s, Stochastic indicator shows the location of the current close relative to the high/low range over a set number of periods. The basic principle used in its development is that during an uptrend prices tend to close near the top of the range, and during a downtrend near the bottom of the range.

If the price closes near the top of the candle indicates buying pressure (accumulation) and if it closes at the bottom indicates selling pressure (distribution).

The Stochastic Oscillator has a great utility especially at significant chart points where traders look for a top or bottom, this indicator helping them to enter or exit positions for greater long term profits.

Stochastic Oscillator has three versions: fast, slow and full. All three versions measure how today close compares to the high-low range of the time period is being considered creating two lines called %K line and %D line.

The Fast Stochastic indicator %K line and %D line are created using following formulas:

Fast %K = (Today's Close – Lowest Low in n) x 100
                  (Highest High in n) – Lowest Low in n)

Fast %D = 3-period moving average of %K

Where n = number of sessions being considered in %K.

The Fast Stochastic indicator is very sensitive, the %K and %D lines crisscrossing the overbought and oversold levels often. This creates false signals and whipsaws.

Slow Stochastic indicator was created to smooth out the data, removing false signals. The Slow %K line is the same as the Fast's %D line and the Slow %D line is a 3 period moving average of the Slow %K line so the formulas used for Slow Stochastic Oscillator look like this:

Slow %K = 3-period moving average of Fast %K

Slow %D = 3-period simple moving average of Slow %K.

The Full Stochastic version is more versatile than the previous two versions because lets the user choose the periods for the Slow %K and Slow %D.

Full %K = N-period moving average of Fast %K (Fast %K is the same as the Slow and Fast versions)

Full %D = N-period simple moving average of Slow %K

Where N = number of sessions being considered in %K and %D.

Lane suggests that a good period to use for the Full Stochastic is 12, which is the most popular. If the Stochastic is used in combination with a trend indicator to see overbought and oversold levels, it can be used periods from 5 to 12.

The default levels for overbought and oversold are 20/80 but if the data is more spread out it can be adjusted to 30/70.

Stochastic Oscillator offers signals by looking for overbought conditions at the 80% level and oversold conditions at the 20% level especially if the %K and %D lines cross over and back through these levels indicating an upcoming reversal.

If the %K and %D lines go up from below 5% or go down from 95% the signals are more reliable.
Sell signals appear if Stochastic crosses above, then below the 80% level, price sets higher highs while Stochastic is setting lower highs (Negative Divergence) and if %K line crosses below %D.

Stochastic Oscillator indicates buy signals if Stochastic crosses below and then above the 20% level, if price sets lower lows while Stochastic is setting higher lows and If the %K line crosses above %D line.

The Stochastic Oscillator indicator can be a very handy tool but as a momentum indicator is better to use its signals combined with information from other technical indicators.