Stochastic Indicators Part 1

The stochastic indicator originally gained a great deal of popularity among futures traders, with the result that the standard formula uses very short term time spans.

The theory behind the indicator, which was invented by George Lane, is that prices tend to close near the upper end of a trading range during an uptrend. As the trend matures, the tendency for prices to close away from the higher end of the trading range becomes pronounced. In a downward moving. market, the reverse conditions hold true.

The stochastic therefore attempts to measure the points in a rising trend at which the closing prices tend to cluster around the lows for the period in question, and vice versa, since these are the conditions that signal trend reversals. It is plotted as two lines, the %K line and the %D line. The %D provides the major signals and is therefore more important.

The formula for calculation of %K is %K= 100[(C- A)/(Hs -A)]

Where C is the most recent close, A is the lowest low for the last five trading periods, and Hs is the highest high for the same five trading periods. Remember that the calculation of stochastic indicators differs from that of most other momentum indicators in that it requires high, low, and closing data for the period in question.

The stochastic formula is similar to the RSI in that the plots can never exceed 0 or 100, but in this case, it measures the closing price in relation to the total price range for a selected number of periods. A very high reading, in excess of 80, would put the closing price for the period near the top of the range, while a low reading, under 20, would place it near the bottom of the range.