These oscillators are based on two fairly straight forward observations. In an uptrend, today’s closing price is likely to be close to the highest value recorded over the last few days. Conversely, in a downtrend, today’s closing price is likely to be close to the lowest value recorded over the last few days. As with all oscillators, the exact number of days (parameter) is set by the user.
In the chart above, the top oscillator is a stochastic and the bottom oscillator is a slow stochastic.
Unlike the RSI, the stochastic oscillator displays two lines and a slow stochastics is “double-smoothed” – this means that there are 3 steps to calculate the three slow stochastic lines.
- %K = Percentage Alert Line
- %D = Percentage Definite Line
- %Dn = Percentage Definite Signal Line
%K represents a measure (on a percentage basis) of where the last closing price lies within the price range of a chosen period. So if the latest closing price is at the high of the last 10 events, then %K = 100% and is it’s currently trading at a 10-event low, then %K = 0%.
As you can see, the fluctuations of %K can be extremely volatile, hence the reason for smoothin this line not once (%D) but twice (%Dn).
NOTE: Slow stochastics (%D & %Dn) are used for market analysis, not simple stochastic (%K & %D).
For a 10-6-6 slow stochastic:
- Ct = Current price, or latest closing price
- L10 = Lowest low for the last 10 events
- H10 = Highest high for the last 10 events
Hence a closing price near or equal to the top of the 10-event price range will give a high value to the %K line, while a close near or equal to the bottom of the price range will give a low reading.
- H6 is the 6-event sum of (Ct – L10)
- L6 is the 6-event sum of (H10 – L10)
- Usually 75% and 25% values are used to identify overbought and oversold situations, although some traders prefer 80/20% (for strong trending markets) or 70/30% (for gentle trending markets, or simply to increase the amount of time spent in the (more interesting) overbought and oversold zones.
- Bullish and bearish divergences are observed the same way as with the RSI.
- The signal to watch for is a divergence between the %D line and the underlying price when the %D line is in the overbought (or oversold) zone.
- A sell signal is given when %D crosses below %Dn in the overbought zone (ideally on the 2nd entry into the overbought zone as the stochastic os creating bearish divergence with the price).
- A buy signal is given when %D crosses above %Dn in the oversold zone (ideally on the 2nd entry into the oversold zone as the stochastic is creating bullish divergence with the price).
- Slow stochastic trading signals should always be confirmed by a trading signal from a primary indicator.
- When confirmation is given this signal is usually strong and accurate.