Stochastics

The Stochastic Indicator was developed by George Lane in the early 1960's. It is based on the observation that as the price of an instrument increases, the daily closes tend to be closer to the upper end of the recent price range. Conversely, as the price decreases, the daily closes tend to be closer to the lower end of the recent price range.

The stochastic values simply represent the position of the market on a percentage basis versus its range over the previous n-period sessions. The percentage scale runs from zero to 100%. The Stochastic Indicator shows where a security's price closed in relation to its price range over the specified time period.

There are three primary stochastic values:

1. Raw Stochastic - the most basic value representing the stochastic value for each period. This is also referred to as raw K.
2. %K - the first smoothing of the raw stochastic, usually with a 3-period exponential moving average.
3. %D - the smoothing of the %k value, usually with another 3-period exponential moving average. Also known as slow K.

There are two parameters for stochastics:

1. The number of periods over which the raw stochastic is calculated. Usually 14, 9, or 20.
2. The smoothing factor for the calculation of percent K and percent D. Usually 3, 5, or 6.

The chart of "Stochastic - raw and %k" is a study of these two values, and is also known as "Fast Stochastic".

The chart of "Stochastic - %k and %d" is a study of these two values, and is also known as "Slow Stochastic".

It should be noted that there are a wide variety of different names for these and similar studies.

Note: Raw K is the inverse of Williams Percent R which uses an upside down scale with zero at the top and 100 at the bottom.

There are several ways to interpret Stochastic Indicators. Three popular methods include:

1. Buy when either %k or %d falls below a specific level (usually 20 or 30%) and then rises above that level. Sell when either %k or %d rises above a specific level (usually 70 or 80%) and then falls below that level.
2. Buy when the %k line rises above the %d line and sell when the %k line falls below the %d line.

The Stochastic Indicator always ranges between 0% and 100%. A reading of 0% shows that the security's close was the lowest price that the security has traded during the preceding n periods. A reading of 100% shows that the security's close was the highest price that the security has traded during the preceding n periods.

To calculate the stochastics:

Assuming parameters of 14,3 find the 14-period high, the 14-period low and the latest price.

The Raw Stochastic is calculated as (latest - 14-period low) / (14-period high - 14-period low) multiplied by 100. Therefore if the 14-period high was 200, the 14-period low was 100, and latest price is 150 (150-100)/(200-100)*100 = 50%

On the third period of data, the %k is the average of the raw values. After the 3rd period %k is the 3-period exponentially smoothed raw values (2/3 old %k + 1/3 new raw stochastic).

After 3 periods of %k, the %d is calculated as a 3-period exponentially smoothed version of %k.

Sample Stochastics Raw and %k Chart:

Sample Stochastics %k and %d Chart:

The calculations and interpretations for Modified Stochastics are the same as those used on the regular Stochastic Indicator, except in the definition of the n-period price range. For some spreads and cash prices, the highs and lows are not always available. In these cases, use the modified stochastic, which defines the range by the highest close and the lowest close in the number of periods specified.

Sample Modified Stochastics Raw and %k Chart:

Sample Modified Stochastics %k and %d Chart: