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Stochastic (STO)

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If you have read the discussion on the Slow Stochastic, you might find the following rather repetitious. The discussion on trading rules is identical to the slow stochastic, however you may want to review the computations, since they are the basis for the slow stochastic values.

Dr. George C. Lane is the author of the stochastic indicator. His basic premise is as follows: During periods of price decreases, daily closes tend to accumulate near the extreme lows of the day. Periods of price increases tend to show closes accumulating near the extreme highs of the day. The stochastic study is an oscillator designed to indicate oversold and overbought market conditions.

Some technical analysts prefer the slow stochastic rather than the normal stochastic. The slow stochastic is simply the normal stochastic smoothed via a moving average technique.

The normal stochastic, like the slow stochastic study, generates two lines. They are %K and %D. The normal stochastic has overbought and oversold zones. Dr. Lane suggests using 80 as the overbought zone and 20 as the oversold zone. Others prefer 75 and 25.

Dr. Lane also contends the most important signal is divergence between %D and the commodity. He explains divergence as the process where the slow stochastic %D line makes a series of lower highs while the commodity makes a series of higher highs. This signals an overbought market. An oversold market exhibits a series of lower lows while the %D makes a series of higher lows.

When one of the above patterns appear, you should anticipate a market signal. You initiate a market position when the %K crosses the %D from the right-hand side. A right-hand crossover is when the %D bottoms or tops and moves higher or lower and the %K crosses the %D line. According to Dr. Lane, your most reliable trades occur with divergence and when the %D is between 10 and 15 for a buy signal and between 85 and 90 for a sell signal.

Parameters:
  • Overall Period (3) - the number of periods used to determine the highest high and lowest low.
  • %D MA Period (14) - the number of periods used to determine the moving average for the %D value.
Computation
The first step in computing the stochastic indicator is to determine the n period high and low. For example, suppose you specified twenty periods for the stochastic. First, the indicator determines the highest high and lowest low during the last twenty trading intervals. It determines the trading range for that time period. The trading range changes on a continuous basis.

The calculations for the %K are as follows:
%Kt = ( (Closet - Lown) / (Highn - Lown) ) * 100
  • %Kt is the value for the first %K for the current time period.
  • Closet is the closing price for the current period.
  • Lown is the lowest low during the n periods.
  • Highn is the highest high during the n time periods.
  • n is the value you specify.
Once you obtain the %K value, you start computing the %D value which is an accumulative moving average. Since the %D is a moving average of a moving average, it requires several trading intervals before the values are calculated properly. For example, if you specify a 20 period stochastic, the software system requires 26 trading intervals before it can calculate valid %K and %D values. The formula for the %D is:
%DT = ( (%DT-1 * 2) + %Kt) / 3
  • %DT is the value for %D in the current period.
  • %DT-1 is the value for %D in the previous period.
  • %Kt is the value for %K in the current period.
The values 2 and 3 are constants. You specify the constants and the length of the time period to examine for the trading range.

Finally, you may compute the stochastic value using the traditional smoothing techniques, a simple moving average, or an exponential moving average. The formulae are not shown here but they are similar to the formulae for the Exponential Moving Average (EMA).

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