STOCHASTIC OSCILLATOR

Stochastic Oscillator
Technical Indicator
Stochastic Oscillator
INTRODUCTION AND HISTORY

The Origins Of The Stochastic Oscillator

by George A. Schade, Jr., CMT

This article answers the longstanding question who originated the %K and %D stochastic oscillator used by market technicians. The question has been debated for years. In center stage are the roles of C. Ralph Dystant (1902-1978) and George C. Lane (1921-2004). The %K and %D stochastic oscillator is commonly associated with Lane. For many years, Lane taught its use. While he cannot be solely credited for originating the indicator, he must be recognized for his life’s work popularizing it.

I. Background

Dystant owned and operated a school called Investment Educators which opened in 1948. The Chicago based school initially offered stock market courses but in the late 1950s began offering commodities courses. In Lane’s words, Investment Educators taught “charting, moving averages, and the Elliott Wave in a series of three classes” and “was the first school to teach a heavy course in Elliott Wave.” Dystant had great interest in the Elliott Wave Principle. He wrote a book entitled “The Fifth Wave – Stocks: A Critique: The Elliott Wave.”

Lane wrote about the origins of stochastics. In an article written for the May/June 1984 issue of Technical Analysis of Stocks and Commodities (TASC), Lane stated that “in 1954,” he “was fortunate to join Investment Educators” working “for the owner, Ralph Dystant, and for the technical ‘guru’, Roy Larson.” When Mr. Larson retired, “Mr. Dystant became the guru for the stock market and [Lane] took the No. 2 spot teaching commodities.”

Lane described the origins of the %K and %D stochastic oscillator as follows:

“These were research days: 20 hour days, all calculating done by hand. The staff expanded to five. I shall not mention names, as
they are all well-off financially, still trading, and don’t wish to be bothered.

In our research, our indicators were running all over the page, so we developed the technique of expressing them as a percentage of
100.

We developed %A, found it didn’t work. We went on to research and to follow 28 oscillators. As we progressed through the oscillators we were developing, we expressed them as percentages as well; thus: %D, %K, %R.….

In the sixties, we pioneered using the computer to test our oscillators.”

In May 1985, the CMT Association Journal (now the Journal of Technical Analysis) published an article written by Lane, in which
he explained that:

“In 1954, I joined Investment Educators as a junior analyst….

After I joined the six-man, no-pay research staff, we discovered oscillators. We researched and experimented with over sixty applications, with the result that we found about twenty-eight that had predictable values. In charting our cumulative oscillators, we found they were running all over the chart paper. Soon, we had chart paper running all over the walls. So, we struck upon the technique of reducing these oscillators to a percentage. We used the alphabet to differentiate one from the other: %A, %B, etc. Each one was reduced to a percentage indicator primarily so we could manage to keep them workable on the chart paper!

As a result of all the hard work (the 14-hour, mostly by hand, no-pay days), we decided that the most reliable indicator was %D
for ‘% of Deviation.’ The basic premise of %D is that momentum leads price.”

Lane noted that the Stochastic Oscillator indicates the momentum of a security’s price movement. It is not a trend indicator for price as, for example, a moving average indicator is. The oscillator compares the position of a security’s closing price relative to the high and low (max and min) of its price range during a specified period of time. In addition to gauging the strength of price movement, the oscillator can also be used to predict market reversal turning points.


The Stochastic Oscillator is a momentum indicator that shows the location of the close relative to the high-low range over a set number of periods. According to an interview with Lane, the Stochastic Oscillator “doesn’t follow price, it doesn’t follow volume or anything like that. It follows the speed or the momentum of price. As a rule, the momentum changes direction before price.” As such, bullish and bearish divergences in the Stochastic Oscillator can be used to foreshadow reversals. This was the first, and most important, signal that Lane identified. Lane also used this oscillator to identify bull and bear set-ups to anticipate a future reversal. As the Stochastic Oscillator is range-bound, it is also useful for identifying overbought and oversold levels.

DEFINITION:

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 calculation above finds the range between an asset’s high and low price during a given period of time. The current security’s price is then expressed as a percentage of this range with 0% indicating the bottom of the range and 100% indicating the upper limits of the range over the time period covered. The idea behind this indicator is that prices tend to close near the extremes of the recent range before turning points. The Stochastic oscillator is calculated:

Stochastic Oscillator

A 3-line Stochastics will give an anticipatory signal in %K, a signal in the turnaround of %D at or before a bottom, and a confirmation of the turnaround in %D-Slow.[4] Typical values for N are 5, 9, or 14 periods. Smoothing the indicator over 3 periods is standard.

KEY TAKEAWAYS

● A stochastic oscillator is a popular technical indicator for generating overbought and oversold signals.

● It is a popular momentum indicator, first developed in the 1950s.

● Stochastic oscillators tend to vary around some mean price level, since they rely on an asset’s price history.

Fast, Slow, or Full

There are three versions of the Stochastic Oscillator available on SharpCharts. The Fast Stochastic Oscillator is based on George Lane’s original formulas for %K and %D. In this fast version of the oscillator, %K can appear rather choppy. %D is the 3-day SMA of %K. In fact, Lane used %D to generate buy or sell signals based on bullish and bearish divergences. Lane asserts that a %D divergence is the “only signal which will cause you to buy or sell.” Because %D in the Fast Stochastic Oscillator is used for signals, the Slow Stochastic Oscillator was introduced to reflect this emphasis. The Slow Stochastic Oscillator smooths %K with a 3-day SMA, which is exactly what %D is in the Fast Stochastic Oscillator. Notice that %K in the Slow Stochastic Oscillator equals %D in the Fast Stochastic Oscillator.

Fast Stochastic Oscillator:

● Fast %K = %K basic calculation

● Fast %D = 3-period SMA of Fast %K

Slow Stochastic Oscillator:

● Slow %K = Fast %K smoothed with 3-period SMA

● Slow %D = 3-period SMA of Slow %K

The Full Stochastic Oscillator is a fully customizable version of the Slow Stochastic Oscillator. Users can set the look-back period, the number of periods for slow %K and the number of periods for the %D moving average. The default parameters were used in these examples: Fast Stochastic Oscillator (14,3), Slow Stochastic Oscillator (14,3) and Full Stochastic Oscillator (14,3,3).

Full Stochastic Oscillator:

● Full %K = Fast %K smoothed with X-period SMA

● Full %D = X-period SMA of Full %K

Produce more headaches than trading results:

1. If 14, 3, 3 is a great setting, why not 13?
2. What about 5, 3, 3?

The shorter the lookback period, the more movement you will get with the indicator The fast Stochastic is ragged in appearance There is no best Stochastic setting that will produce more wins than losses.

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