Description of the Method
The stochastic oscillator trading method is a useful strategy that provides professionals with an opportunity to identify market changes accurately. It is based on oscillators that are treated as repetitive actions the analysis of which allows finding out the most anticipating market direction, which is aligned with the very meaning of the word “stochastic” that can be perceived as “guess.” This accurate precision is measured with the help of a scale. It describes the degree of price alteration within a closing period. As a result, the possibility to predict how long the current direction will remain the same can be obtained.
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The discussed simple momentum oscillator was developed in the middle of the 20th century. Its creator was George C. Lane, a technical analyst who contributed to this field significantly and affected the work of financial professionals and traders, as Lane’s stochastics allows describing the situation with a currency pair. For instance, it shows whether it is overbought or oversold.
Taking into consideration the fact that stochastic oscillator has already been used for more than 50 years, it cannot be denied that it is both valid and reliable. It has stood the test of time and appealed to numerous professionals who benefited from its utilization. Thus, it is not surprising that a lot of traders use it nowadays in order to reveal how strong or weak the current trend is to find out both overbought and oversold market conditions.
The stochastic oscillator presupposes that uptrend market prices are not below the previous period closing price while downtrend prices are not above the previous closing price. It consists of two lines on a price chart: stochastic fast (%K) and slow (%D). The first one shows the current market rate while the second one reveals a moving average of %K that reacts to market price slower.
Utilization of the Method
As it has already been mentioned, the stochastic oscillator provides professionals with an opportunity to find out the relationships between the currently observed price and the highest/lowest price, focusing on a particular period of time that took place in the past. As a rule, traders use it to describe those changes that have been observed during 14 periods. They can reveal different time frameworks, such as hours, days, or weeks. The indicator is volatile between 0 (the lowest low) and 100 (the highest high). In this way, if it is near 0, the price is trading near the highest high; if it is above 50, the price is trading in the upper section of the selected period of time; if it below 50, the price is trading within the lower section.
To calculate stochastic oscillator values, a few steps should be made. This necessity is associated with the presence of two lines (%K and %D). Traders use the following equations in order to identify them:
- %K = (Current Close – Lowest Low) / (Highest High – Lowest Low) x 100
- %D = 3-Day Simple Moving Average of %K
During the calculation, it is important to keep in mind that both the lowest low and the highest high are considered for the previously observed time that is usually associated with 14 periods.
The described formula is used when dealing with fast stochastic. When there is a necessity to utilize a slow stochastic version, the following equations should be considered:
- Slow %K = 3-Period SMA of Fast %K
- Slow %D = 3-Period SMA of Slow %K
These two variants of the stochastic oscillator equation are similar, but in the second formula 3 periods are considered, which makes it less choppy. This fact makes traders utilize the slow stochastic in the majority of cases.