Stochastic Oscillator is an oscillator which delivers the signals based on momentum of the stock. The indicator swings between 0 and 100 which are its extreme boundaries. Like RSI, Stochastic too have observable levels of 20 and 80. Whenever the oscillator reaches 20, it indicates that the stock is undervalued and reached it oversold zone. This gives raise to a view that the security may take U-turn and move in the opposite direction (towards 80 levels) from thereon. As well if the stock reaches 80, it may be under overvalued stocks and have high chances of moving down. This theory works well in consolidated markets.
There are 2 types of stochastic oscillators in use. Though the original version developed is fast stochastic, later when it was smoothened with Simple Moving Average, slow stochastic became more familiar in predicting the overbought/oversold securities.
Fast stochastic Oscillator
As always, for fast stochastic oscillator too, selection of time periods hold key and the recommended time frame is 14 periods. Doesn’t matter whether it’s fast or slow stochastic, both have %K as well %D lines in their oscillators as shown in the above chart. %K is calculated as per the time frame selected. Once after %K is calculated, certain value of Simple Moving Average is applied to %K to get %D. It’s obvious that %k moves faster when compared with %D.
Slow stochastic Oscillator
This is a smoothened fast stochastic oscillator. The initial %K value which was derived in fast stochastic is again smoothened with certain value of simple moving average and %K of slow stochastic is extracted (exactly same procedure how %D was calculated in fast stochastic). This is the reason; both %D of fast stochastic and %K of slow stochastic holds same value provided both are smoothened with same SMA. Now the left parameter to be calculated is %D of slow stochastic oscillator. Once again, SMA is applied to %K of slow stochastic to get %D
Calculation procedure goes as follows:
First, %K of fast stochastic oscillator is calculated
Second, %D of fast stochastic
Third, %K of slow stochastic
Finally, %D of slow stochastic oscillator is derived.
Fast Stochastic Oscillator:
- Fast %K = %K basic calculation
- Fast %D = 3-period SMA of Fast %K
Slow Stochastic Oscillator:
- Slow %K = Fast %K smoothed with 3-period SMA
- Slow %D = 3-period SMA of Slow %K
No reason to learn the above calculation as everything is done by software but need to learn the application part.
Three applications can be used with the help of these stochastic oscillators:
2. Crossover of %k with %D
As discussed above, if %K (No need of second swing line, %D) of a particular security reaches 20, it is assumed that the stock is oversold and enters into bull phase again. If %K touches 80 or nearby, the stock is said to be at overbought zone and selling volumes may start increasing. If the oscillator is in between 20 and 80 without touching either, it seems to be that the stock is in the sideways.
In this type of application, both %K and %D comes into the picture. If %K cuts %D in the downward direction, it is said that the security may fall and if %K cuts %D in the upward direction with good volumes, then the stock may enter into the bull zone.
Note: Combination of both first and second applications may give better results in most of the cases.
Divergence remains same as we have discussed in our previous articles. When the stock price is making higher highs (New highs) and the oscillator in the stochastic indicator is makes Lower highs, it gives a sign that the security is interested to move in the upper direction pointing the future trend downwards which generates a sell signal.
When the security closing price is making lower lows and the swing oscillator makes higher lows, it throws a warning signal that the stock is not tending to move downside more and at this point, the stock may start moving upward generating a buy signal.