Technical Studies: Full Stochastic Oscillator

The Full Stochastic Oscillator compares the most recent closing price for a security against its relative price range over a specified period. Crossovers of the two lines in the study often generate signals indicating a reversal of the current price trend for that security.

A reading of 100 indicates that the security closed at its trading high during a given period; a reading of zero indicates that the security closed at its given low during the period. A reading of 80 or higher may indicate an overbought condition (price decline may be due), while a reading of 20 or lower may indicate an oversold condition (price rise may be due).

Some technical analysts buy when the "fast" line on the Stochastic Oscillator, the %K, moves up past 20. Similarly, they sell when the %K peaks and turns below 80. In general, buy and sell signals are also formed when %K falls below (sell) or rises above (buy) the %D. The %D is usually a short-term (e.g., three-period) Simple Moving Average of the %K, so crossover signals are common and may not be consistently reliable.

Buy and sell signals also arise when the %K and the security's price experience a divergence and the %K is in oversold/overbought territory. A bullish divergence situation occurs when a security's price reaches lower lows while the %K forms a higher low. The buy signal may appear when the %K crosses above the 20 level. A bearish divergence situation occurs when a security's price reaches higher highs while the %K forms a lower high. The sell signal may appear when the %K crosses below the 80 level.

Here's how the three default parameters for the Stochastic Oscillator (14, 1, 3) work:

• The first parameter, 14, indicates that number of periods (minutes/hours/days/weeks/months) to include in the calculation of the %K (fast) line.
• The third default parameter, 3, indicates the number of periods to include in the calculation of the %D (slow) line. By default, the %D (slow) line is a 3-period SMA of the %K (fast) line, meaning that it is plotted based on the average closing value of the %K (fast) line over the last three periods.
• The middle parameter, 1, indicates what smoothing factor, if any, to apply when plotting the %K (fast) line. By default, a 1-period SMA of the %K (fast) line is plotted, meaning that no smoothing factor is applied to the %K (fast) line. Changing the middle parameter to 3, for instance, applies a 3-period SMA to the %K (fast) line, meaning that the %K (fast) line is plotted based on its average closing value over the last three periods.

All three parameters can be customized. The 14, 1, 3 default parameters plot what technical analysts commonly refer to a as a Fast Stochastic, which generates frequent buy/sell signals. Changing the middle parameter to 2 or higher smoothens the %K (fast) line, creating %K and %D lines that are less responsive to sudden price fluctuations.

Calculating the Full Stochastic Oscillator: The Stochastic Oscillator consists of two lines, the %K and the %D.
%K = (Recent close - Lowest low during period)
divided by (Highest high during period - Lowest low during period)
× 100
%D = the 3-period Simple Moving Average of the %K