Stochastics are an oscillator developed by George Lane and are based on the following observation:
As prices increase - closing prices tend to be closer to the upper end of the price range
As prices decrease - closing prices tend to be closer to the lower end of the price range
Slow Stochastics are based on Fast Stochastics but provide a slower, smoother response to price movements.
Slow Stochastic consist of two lines, %K and %D:
The %K line in Slow Stochastic is the same as the %D line in Fast Stochastic.
The %D line in Slow Stochastic is a Simple Moving Average of %K Slow Stochastic. This line is smoother than the %K and provides the signals for an overbought / oversold market.
Slow Stochastics are the more commonly used of the two Stochastic types - Fast and Slow. This is because Slow Stochastics are smoother and are less likely to give false signals.
The most common uses of Stochastics are to:
- Indicate overbought and oversold conditions
An overbought or oversold market is one where the prices have risen or fallen too far and are therefore likely to retrace. If the %D line is above 80% then the close is near the top end of the range of the observation period, while a reading below 20% means that the close is near the bottom end of the range of the observation period.
Generally the area above 80 is considered overbought, while the area below 20 is oversold. The specified overbought/oversold ranges vary. Other commonly used ranges include 75-25, 70-30 and 85-15.
Overbought and oversold signals are most reliable in a non-trending market where prices are making a series of equal highs and lows. If the market is trending, then signals in the direction of the trend are likely to be more reliable.
For example if prices are in a downtrend, a safer trade entry may be obtained by waiting for prices to pullback giving an overbought signal and then turn down again.
- Generate buy and sell signals
For a buy or sell signal the following conditions must be met in order.
1. The %K and %D lines move above 80 or below 20
2. The %K and %D lines cross
3. The %K and %D lines move below 80 or above 20
- Indicate Bullish and Bearish Divergence
Divergence between Stochastics and the price indicates that an up or down move is weakening.
Bearish Divergence occurs when prices are making higher highs but the Stochastics are making lower highs. This is a sign that the up move is weakening.
Bullish Divergence occurs when prices are making lower lows but the Stochastics are making higher lows. This is a sign that the down move is weakening.
Observation period for %K Fast: (default 5)
Fast %K is used to calculate Slow %K, but is not charted.
Averaging period for %K Slow: (default 5)
This is the same as the%D Fast in Fast Stochastics. The averaging period is the number of observations of %K Fast used in the moving average.
Averaging period for %D Slow: (default 3)
This is the number of observations used in the moving average of %K Slow. The smaller the value the closer the %D will be to the %K.