Stochastic

The Stochastic is another indicator that helps us determine where a trend might be ending.

By definition, a Stochastic is an oscillator that measures overbought and oversold conditions in the market. The 2 lines are similar to the MACD lines in the sense that one line is faster than the other.As we said earlier, the Stochastic tells us when the market is overbought or oversold. The Stochastic is scaled from 0 to 100. 

Stochastic Fast

Stochastic Fast plots the location of the current price in relation to the range of a certain number of prior bars (dependent upon user-input, usually 14-periods). In general, stochastics are used to measure overbought and oversold conditions. Above 80 is generally considered overbought and below 20 is considered oversold. The inputs to Stochastic Fast are as follows:

• Fast %K: [(Close - Low) / (High - Low)] x 100
• Fast %D: Simple moving average of Fast K (usually 3-period moving average)

Stochastic Slow

Stochastic Slow is similar in calculation and interpretation to Stochastic Fast. The difference is listed below:

• Slow %K: Equal to Fast %D (i.e. 3-period moving average of Fast %K)
• Slow %D: A moving average (again, usually 3-period) of Slow %K

The Stochastic Slow is generally viewed as superior due to the smoothing effects of the moving averages which equates to less false buy and sell signals. A comparison of the two stochastics, fast and slow, is shown below in the chart

Full Stochastic Oscillator (Full STO)

The combination of the Slow Stochastic and the Fast Stochastic is called a Full Stochastic. It uses 3 parameters:

The uniqueness of Slow Stochastic is that it uses a "smoothing factor" for the initial %K line that is "n-period" SMA (n is the same number as the middle parameter) of the initial %K line

The Full Stochastic Oscillator is more advanced and more flexible than the Fast and Slow Stochastic and can even be used to generate them. For example, a (14, 1, 3) Full Stochastic is equivalent to a (14, 3) Fast Stochastic while a (12, 3, 2) Full Stochastic is identical to a (12, 2) Slow Stochastic.

Much as the Fast and Slow Stochastics, the number of periods used to create the initial %K line, is defined by the first parameter. %D is again the number of periods that is used to create the signal line.
Readings above 80 act as an overbought signal while readings below 20 act an oversold signal. However, even if the Stochastic Oscillator has reached 80 securities can continue to rise. Similarly, even after it has reached 20 it can continue to fall.

Stochastics Buy & Sell Signals

Stochastics Buy Signal

When the Stochastic is below the 20 oversold line and the %K line crosses over the %D line, buy.

Stochastics Sell Signal

When the Stochastic is above the 80 overbought line and the %K line crosses below the %D line, sell.
Stochastic Fast buy and sell signals are illustrated below in the chart

 Stochastic Slow is presented below in the chart of the contract. Notice how much smoother the %K and %D lines are and how many fewer false signals were given by the Stochastic Slow than were given by the Stochastic Fast indicator.

 In addition to giving clear buy and sell signals, the Stochastic technical analysis indicator is also helpful in detecting price divergences and confirming trend.

Stochastic Price Divergences

Stochastics can be used to confirm price trend. In the example below of the chart, the Stochastic indicator spent most of its time in the overbought area. When Stochastics get stuck in the overbought area, like at the very right of the chart, this is a sign of a strong bullish run. Signals to sellshort would be ignored; however, before the signal not to short was given, many losses unfortunately would have accrued from failed shorting attempts on the left half of the chart.

A powerful and more common occurence is Stochastic divergences. The chart below illustrates Stochastic divergences and confirmations:

Low #1 to Low #2

The Stochastic Slow confirmed the upward movement of gold futures prices by making a higher low.

High #1 to High #2

Gold futures rallied to make a higher high; however, the Stochastic Slow indicator failed to make a higher high, instead it made a lower high. This divergence coupled with a trendline break in the price of gold would be a strong warning to futures traders that the recent rally had probably ended and any long futures positions should be exited or at least scaled back.

Low #3 to Low #4

Gold prices continued its downward tumble, making a lower low at Low #4. On the other hand, the Stochastic Slow indicator was signaling a higher low. This bullish divergence would have warned traders to exit their shortsells, the price of gold had a strong potential of bottoming.