A stochastic oscillator is a momentum indicator comparing a particular closing price of a security to a range of its prices over a certain period of time. The sensitivity of the oscillator to market movements is reducible by adjusting that time period or by taking a moving average of the result. It is used to generate overbought and oversold trading signals, utilizing a 0–100 bounded range of values.
The Formula for the Stochastic Oscillator Is
%K=( H14−L14C−L14 )×100
C = The most recent closing price
L14 = The lowest price traded of the
14 previous trading sessions
H14 = The highest price traded during the same14-day period
%K = The current value of the stochastic indicator.
Notably, %K is referred to sometimes as the fast stochastic indicator. The “slow” stochastic indicator is taken as %D = 3-period moving average of %K.
The general theory serving as the foundation for this indicator is that in a market trending upward, prices will close near the high, and in a market trending downward, prices close near the low. Transaction signals are created when the %K crosses through a three-period moving average, which is called the %D.
The difference between the slow and fast Stochastic Oscillator is the Slow %K incorporates a %K slowing period of 3 that controls the internal smoothing of %K. Setting the smoothing period to 1 is equivalent to plotting the Fast Stochastic Oscillator.