Stochastics (K%D)
posted under
Philosophy of Technical Analysis
by ceecabolos
The Stochastic oscillator was popularized by George Lane (president of Investment Educators, Inc., Watseka, IL). It is based on the observation that as prices increase, closing prices tend to be closer to the upper end of the price range. Conversely, in downtrends, the closing price tends to be near the lower end of the range. Two lines are used in the Stochastic Process—the %K line and the %D line. The %D line is the more important and is the one that provides the major signals.
The intent is to determine where the most recent closing price is in relation to the price range for a chosen time period. Fourteen is the most common period used for this oscillator. To determine the K line, which is the more sensitive of the two, the formula is:
%K = 100 [(C - L14) / (H14 - L14)]
where C is the latest close, L14 is the lowest low for the last 14 periods, and H14 is the highest high for the same 14 periods (14 periods can refer to days, weeks, or months).
The formula simply measures, on a percentage basis of 0 to 100, where the closing price is in relation to the total price range for a selected time period. A very high reading (over 80) would put the closing price near the top of the range, while a low reading (under 20) near the bottom of the range.
The second line (%D) is a 3 period moving average of the %K line. This formula produces a version called fast stochastics. By taking another 3 period average of %D, a smoother version called slow stochastics is computed. Most traders use the slow stochastics because of its more reliable signals.*
These formulas produce two lines that oscillate between a vertical scale from 0 to 100. The K line is a faster line, while the D line is a slower line. The major signal to watch for is a divergence between the D line and the price of the underlying market when the D line is in an overbought or oversold area. The upper and lower extremes are the 80 and 20 values. (See Figure 10.15.)
A bearish divergence occurs when the D line is over 80 and forms two declining peaks while prices continue to move higher. A bullish divergence is present when the D line is under 20 and forms two rising bottoms while prices continue to move lower. Assuming all of these factors are in place, the actual buy or sell signal is triggered when the faster K line crosses the slower D line.
There are other refinements in the use of Stochastics, but this explanation covers the more essential points. Despite the higher level of sophistication, the basic oscillator interpretation remains the same. An alert or set-up is present when the %D line is in an extreme area and diverging from the price action. The actual signal takes place when the D line is crossed by the faster K line.
The Stochastic oscillator can be used on weekly and monthly charts for longer range perspective. It can also be used effectively on intraday charts for shorter term trading. (See Figure 10.16.)One way to combine daily and weekly stochastics is to use weekly signals to determine market direction and daily signals for timing. It's also a good idea to combine stochastics with RSI.
The intent is to determine where the most recent closing price is in relation to the price range for a chosen time period. Fourteen is the most common period used for this oscillator. To determine the K line, which is the more sensitive of the two, the formula is:
%K = 100 [(C - L14) / (H14 - L14)]
where C is the latest close, L14 is the lowest low for the last 14 periods, and H14 is the highest high for the same 14 periods (14 periods can refer to days, weeks, or months).
The formula simply measures, on a percentage basis of 0 to 100, where the closing price is in relation to the total price range for a selected time period. A very high reading (over 80) would put the closing price near the top of the range, while a low reading (under 20) near the bottom of the range.
The second line (%D) is a 3 period moving average of the %K line. This formula produces a version called fast stochastics. By taking another 3 period average of %D, a smoother version called slow stochastics is computed. Most traders use the slow stochastics because of its more reliable signals.*
These formulas produce two lines that oscillate between a vertical scale from 0 to 100. The K line is a faster line, while the D line is a slower line. The major signal to watch for is a divergence between the D line and the price of the underlying market when the D line is in an overbought or oversold area. The upper and lower extremes are the 80 and 20 values. (See Figure 10.15.)
A bearish divergence occurs when the D line is over 80 and forms two declining peaks while prices continue to move higher. A bullish divergence is present when the D line is under 20 and forms two rising bottoms while prices continue to move lower. Assuming all of these factors are in place, the actual buy or sell signal is triggered when the faster K line crosses the slower D line.
There are other refinements in the use of Stochastics, but this explanation covers the more essential points. Despite the higher level of sophistication, the basic oscillator interpretation remains the same. An alert or set-up is present when the %D line is in an extreme area and diverging from the price action. The actual signal takes place when the D line is crossed by the faster K line.
The Stochastic oscillator can be used on weekly and monthly charts for longer range perspective. It can also be used effectively on intraday charts for shorter term trading. (See Figure 10.16.)One way to combine daily and weekly stochastics is to use weekly signals to determine market direction and daily signals for timing. It's also a good idea to combine stochastics with RSI.
Comment Form under post in blogger/blogspot