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StochasticClick to Enlarge
The stochastic oscillator is another measure of market momentum. The oscillator measures momentum by tracking the current closing price relative to a lookback period of the recent range (high – low). It is used to identify overbought/oversold situations and price and momentum divergence, as well as confirmation of a trending market.

There are two versions of the stochastics oscillator, the slow and the fast stochastics. The slow stochastic is derived from the more sensitive, fast stochastic. The fast stochastic plots two lines, called %K and %D.

 

 

 

 

Fast Stochastics
The 10-bar fast stochastic calculations are as follows:
%K = 100[(C - L10)/(H10 - L10)]
where C = last close and H10 is the highest high in the last 10 bars and L10 is the lowest low in the last 10 bars.

%D is a proxy for a three-period smoothed average of %K.
%D = 100(H3/L3)
where H3 is the three-period sum of (C- L10) over the last three bars and L3 is the three-period sum of (H10-L10) for the last three bars.

The settings are (10,3), which is a 10-bar lookback and a three-period smoothing.

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CQG traders have a choice of the number of bars in the lookback period, the number of bars for the smoothing, and the choice of smoothed, simple, exponential, weighted, and centered moving averages.

Chart 1 is an example of the fast stochastic. The %K line is volatile as it tracks the closing price relative to the highest high and lowest low over the last 10 bars. The %D line smoothes out this volatile oscillator line.

Slow Stochastics
The slow stochastic calculates the fast stochastic %K and %D, but does not plot the original %K; instead, it uses the %D value from the fast stochastic and labels it as %K. The new %D line is a three-period average of the new %K. The settings would be (10,3,3), but only the (3,3) lines are plotted. See chart 2 for a comparison between the two versions.

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As with the fast stochastics, CQG traders have a choice of the number of bars in the lookback period, the number of bars for the smoothing, and the choice of smoothed, simple, exponential, weighted, and centered moving averages.

In addition, CQG traders have a choice between using the original calculation or a simple algorithm. The original calculation smoothes the numerator and denominator of the ratio separately, and then divides. The simple algorithm calculates the ratio first, and then smoothes the result.

The simplified algorithm for a 10-bar slow stochastic is a three-bar moving average of the ((C- L10) / (H10-L10)). Generally, the simplified algorithm is more responsive to price movements.

Usage
The standard use for the stochastics oscillator is that a stochastic value above 75 indicates an overbought market, while a stochastic reading below 25 indicates an oversold market.Click to Enlarge

The crossing of the %K below %D lines generates a sell signal when the stochastic has reached the overbought level of 75, and then drops below 75. Waiting for the %D to drop below 75 will reduce the likelihood of a false signal in a strong upward trend (chart 3).

Buy signals occur when the %K crosses above %D when the stochastic has reached the oversold level at 25, and then climbs above this level. When the %D is still below 25, buy signals tend to be false when the market is in a weak downtrend (chart 4).Click to Enlarge

Traders look for the price and the stochastic to diverge. When the slow %K and slow %D values decline and closing prices increase, then upside momentum is waning. Or if the slow %K and slow %D values rise while the closing prices continue to drop, then the divergence indicates a loss of downward price momentum.

The normal setting for the slow stochastic is (10,3,3); a little longer lookback of (14,3,3) can be overly sensitive to price movement. Changing the settings to a longer period such as 21,13,8 will give less frequent crossovers, and the overbought/oversold levels will be more realistic, as they will occur less often.

Finally, if tClick to Enlargehe market is in a strong uptrend, the %K and % D will not drop down to 25. Or, they will reach 75 if the market is in a weak downtrend. If the price action is working its way higher and the %K is crossing back above the %D in the 40-50 range, then you will have confirmation of a strong market because the stochastic oscillator is turning up well above the normal oversold level. In a similar fashion, during a weak market, the stochastic will not rise to the 75 level, but will peak between 50 and 60.


 

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