Cashing In on Stochastics

Another useful indicator with an extremely clumsy name is the stochastic oscillator. This momentum indicator considers the current closing price of a security in relation to a high-low range of prices over a set number of look-back periods. This oscillator can be very useful when used in tandem with your candlestick charts. And in addition to its usefulness as an indicator of momentum, the stochastic oscillator may also be used as an overbought or oversold indicator when readings are at extreme levels: 30 percent for oversold and 70 percent for overbought (see the section on RSI earlier in this chapter).

Grasping the math behind the stochastic oscillator

George Lane developed the stochastic oscillator in the late 1950s. The math behind it is pretty remarkable for an indicator some 50 years old. There are actually two readings for a stochastic oscillator that are combined on a chart. They’re referred to as the slow (%D) and the fast (%K) stochastics. The slow one is generally a moving average of the fast one.

The formulas for the slow and fast stochastic oscillators are as follows:

bullet Fast Stochastic:

%K = 100 × (Recent Close – Lowest Low(n) ÷ Highest High(n) – Lowest Low(n))

N = number of periods used in calculation

bullet Slow Stochastic:

%D = 3-period ...

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