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Stochastic OscillatorThe Stochastic Oscillator is another popular oscillator that is widely used by traders. The premise behind its calculation is that when a security is rising, it tends to close near the high of a recent period and a falling security closes near its low. So, the Stochastic Oscillator actually measures the price of a security relative to the high/low range over a set period of time. Thus it provides an indication of where the security is presently trading within its recent trading range. The formula for the Stochastic Oscillator (%K line) is:
where: C = Present closing price The Stochastic Oscillator is plotted on the chart as depicted below:
The Stochastic Oscillator is plotted between the values of 0 and 100 and has reference lines placed at 20 and 80. The Stochastic Oscillator can be interpreted a number of ways which include crossing the reference lines, i.e. when the Stochastic crosses up above 20, then buy and when the Stochastic crosses down below 80, sell. Support and resistance can also be seen in the Stochastic and may be more evident than on the chart itself. Another interpretation is readings below 20 are considered oversold and readings above 80 are considered overbought. As such, this indicator lends itself well to positive/negative divergences. The second dotted line on the chart is known as the %D line. The %D line is a short moving average of the %K line and using crossovers between the two lines can provide slightly earlier signals. Another variable with the Stochastic Oscillator is the ‘Slowing Factor’. This will help smooth out the %K line by taking the last ‘x’ number of periods and using the average of the closing prices from all those periods, as opposed to the latest closing price. This helps remove an erratic behaviour from the oscillator. It can be combined with other technical indicators or patterns to assist you in your entry decision.
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