Calculate and Interpret the Stochastic Oscillator
A Stochastic Oscillator, also known as a Stochastic Indicator is used to compare the close price of a security to its trading range over a defined period of time. Developed by George Lane in the 1950’s, the indicator is used to measure price momentum through the examination of a pre-determined high to low range and comparing the security’s closing price to its price range over that time period. The theory behind the use of the stochastic oscillator is that in a market that is trending upward, prices will close near the high end of the range; the opposite is true is downward-trending markets.
Calculate the Stochastic Oscillator
The formula can be written as follows:
%K = 100[(C – L)) / (H – L)]
Where:
C = the most recent closing price of the security
L = the low price of the 14-day period
H = the highest price traded during the same 14-day period.
%D = 3-period moving average of %K
The output, represented by %K, is a percentage figure that will vary (“oscillate”) between 0 and 100 over a period of time.
The most commonly used period for the calculation is 14 days. The highs and lows are recorded for each of the 14 days and the recent close would be the closing price on the 14th day. A 3-day moving average of %K, called %D, is typically plotted to act as a signal or trigger line. It effectively smoothes out the oscillations and makes it easier to identify the change in trend.
Interpreting the Stochastic Oscillator
There are several ways to interpret the oscillator. Three popular approaches include:
• A buy signal may be indicated when the Oscillator (either %K or %D) drops below a specified level (20 is often used) and then rises above that level. Sell when the Oscillator rises above a specified level (80 is often used) and then drops below that level;
• A Buy signal may also be indicated when the %K line rises above the %D line.
• A sell signal may be indicated when the %K line drops below the %D line
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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.
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