Tips on Technicals - Stochastics
Indicator type: |
Momentum oscillator |
Used to: |
Identify market strength, overbought/oversold |
Markets: |
All cash and futures, not options |
Works Best: |
Flat markets or trading ranges |
Formula: |
Fast %K = |
last price - "n" period lowest low "n" period highest high - lowest low
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Fast %D =
Slow %K =
Slow %D =
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3 period moving average of Fast %K
Fast %D
3 period moving average of Slow %K
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Parameters: |
"N" values are typically 14 for all markets although 9 period and 20 period values are used to make the values more or less sensitive, respectively. The moving average type used to derive %D was originally defined to be simple although modified averages are more popular. |
Theory: |
A stochastic is the measurement of the placement of a current price within a recent trading range. The theory is that as prices rise, daily (or hourly, minute, etc.) closes tend to occur closer to the high end of their recent range. When prices trend higher or are flat and daily closes begin to sag within the range, it signals internal market weakness. |
Interpretation: |
Values above 75 or below 25 are potential market signals. Aside from smoothing out fluctuations, the "%D" value adds two other dimensions to the analysis. Crossovers between the "%K" and "%D" and divergences between the stochastic and the price trend, both within the overbought and oversold ranges, provide additional evidence of reversals in the market.
The fast stochastic will tend to show many crossovers and therefore could show false signals to the inexperienced user of this technique. The less sensitive stochastic, called the slow version, will show fewer crossover signals, but each one is more likely to catch true near-term market reversals. One caution would be that extreme readings in strongly trending markets can be continuation, not reversal, signals. This study is better suited to slower market conditions.
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Above is 14 days of hourly trading for Time-Warner Inc. with 14-period Slow Stochastics. This stock traded in a half point range for three days. Stochastics, while rising for over two days, remained mostly in the bearish range under 40 and exhibited a bearish move lower early on the third day before price broke down.