The Stochastic oscillator was made famous by George Lane. It's premise is that in an uptrend, closing prices have a tendency to close at the upper end of the price range. In a downtrend, prices tend to close near the lower end of the price range. The two lines used by Stochastic are the %K line and the %D line. The %K line is more sensitive of the two and the formula is:
%K = 100 [(C - L14)] / (H14 - L14)]
C = the latest close
L14 = the lowest low for the last 14 periods
H14 = the highest high for the same 14 periods
The formula measures from 0 to 100 on a percentage basis where over 80 would be a closing price near the top of the range and below 20 would a closing price near the bottom of the range.
The %D line is the second line. This is a 3 day moving average of the %K line. This formula is known as fast stochastics. If you take another 3 period average of %D, the result is known as slow stochastics. Slow stochastics tends to give more reliable signals than fast stochastics.
As the image shows, the fast stochastics tends to give a more erratic signal than the slow stochastics oscillator.
Stochastics can be used on minute, daily, weekly or monthly charts. The indicator usually works best in a sideways market. When using stochastics, use another indicator such as the RSI indicator to confirm the signal.
Ways to use the Stochastic Oscillator
The first and most common way that stochastics is used is to look for divergence between price and the stochastic signal. If the price of an equity continues to move higher while the %D line makes 2 lower highs above 80, this is bearish divergence. On the other hand, if a stock is makes lower lows and the %D line makes 2 higher lows below 20, this bullish divergence. The actual buy or sell signal comes when the %K line crosses over the %D line. Many will use divergence even if the oscillator is not in overbought (above 80) or oversold territory (below 20).
Jake Bernstein, author of The Compleat Day Trader, uses the slow stochastic oscillator in day trading in a different way. Mr. Bernstein recommends using 5min, 10 min or 15 min charts for this method. He also uses 75 as the top of the range and 25 as the bottom of the range. His findings showed that when a stock was moving higher and the %K line crossed over 75 (overbought) the stock would usually explode higher and should be bought. He states to close the position when the %K line crosses below the %D line, even if the cross occurs above 75.
To short a stock using this method, Mr. Bernstein would look for the %K line to go below 25 and not cover until the %K line crossed above the %D line, even if it is below 25.
The last method is one that I use. If the market is trending in one direction, I will use the Slow Stochastic Oscillator to time my entry points. I will only trade in the direction of the trend. For example, if stock XYZ is in a strong uptrend and is now pulling back, I will look to enter a long position when the stochastic indicator has corrected and has turned up with the %K moving above the %D. I like to confirm that XYZ is still strong by confirming the move using a RSI>50.
If a stock is in a downtrend, I will look to initiate a short when the stock bounces higher but fails to break the trend. I will wait for the stochastic indicator to turn down and the %K line to fall below the %D line. I also use a RSi<50 to confirm the move.
This method can be used on daily charts, swing trades and day trades. The signal will be less reliable as the period shrinks.
These are just 3 methods of using the Stochastic Oscillator. There are many others. Some people change the time periods to a shorter period for a quicker response. Some will buy only when the indicator crosses from oversold (below 20) to trending up (above 20). No matter how you choose to use the indicator, the key is to not keep adjusting it. Use it one way and stick to your rules. No indicator is perfect. The object is to have a disciplined approach and follow it.