Introduction
Stochastic Process was invented by Dr. George C. Lane many years ago
under this basic premise: During periods of decrease daily closes tend
to accumulate near the extreme low of the day and conversely, during
periods of increase daily closes tend to accumulate near the extreme
highs of the day.
This indicator is designed to show conditions of overbought and oversold
markets. Stochastics are divided into two types: Regular Stochastics,
often referred to as Fast Stochastics, and Slow Stochastics. Fast
Stochastics are said to be more sensitive to price changes and can give
very greatly in the short-term, hence the need for Slow Stochastics.
Interpretation
Stochastics display two lines that move in a vertical scale between 0
and 100 - representing percentiles from 0% to 100%. Think of the level
of Stochastics as where the most current close is within a specific
range. For example, if Stochastics are reading 50%, the current close is
in the middle of the price range for a specified period of time. If
Stochastics are reading 100%, the close is at the high of the range, and
0% represents the current close price being at the low of the range.
Because Stochastics are smoothed, this is not exactly true, but should
help you visualize the information being shown. This will also help you
to understand why Stochastics are a counter trend indicator, in that the
underlying principle behind Stochastics is that prices will move back to
the center of the trading range, or the opposite extreme.
When both lines move to an area below 20 on this scale they are said to
be in an oversold zone. Conversely, when both %K and %D move to above 80
on this same scale they are indicating an overbought zone. It is this
indication of market sentiment that makes this counter trend indicator
useful.
George Lane emphasized that the most important signal generated by this
method was the difference or divergence between %D and the underlying
market price. He said that the divergence is where %D line makes a group
of lower highs while the market makes a series of higher highs. This
would indicate an overbought condition. The reverse would be true of an
oversold market, with %D making higher lows and prices making lower
lows.
Trade triggers to buy are created when, during an oversold condition (Stochastics
below 20) the slow line, %D is crossed by the faster moving line, %K.
The opposite would occur with a sell signal. The faster %K line crosses
above the slower %D line, when both are at a reading above 80.
As with a dual moving average system, when the faster reacting indicator
crosses the slower moving indicator, a buy or sell is signaled. Because
Stochastics give an indication of either overbought or oversold, you
would first want to see both lines in the above 80 or below 20 range,
and sloping out of that range back to the middle before looking for
these trade triggers.
Example of FSTO in the Indicator Window:
Calculation
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. |
Formula:
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. Determine 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: The value for the first %K for the current time period.
Closet: The closing price for the current period.
Lown: The lowest low during the n periods.
Highn: The highest high during the n time periods.
n: 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: The value for %D in the current period.
%DT-1: The value for %D in the previous period.
%Kt: 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.
Customizing
To change the settings of this indicator, open the Program Options
screen by clicking the "Program Options" button located on the main
Toolbar.
See the Program Options section for more details on changing the
settings.
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