Using a scale to measure the degree of change between prices from one closing period to the next, the Stochastic Oscillator attempts to predict the probability for the continuation of the current direction trend.
Forex Technical Analysis How To Use Stochastic Oscillator
The Stochastic Oscillator was created by George C. Lane and introduced to the trading community in the late 1950s. It was one of the first technical indicators used by analysts to provide insight into potential future market direction and is based on the premise that during a market uptrend, prices will remain equal to or above the previous period closing price. Alternatively, in a market downtrend, prices will likely remain equal to or below the previous closing price.
Using a scale to measure the degree of change between prices from one closing period to the next, the Stochastic Oscillator attempts to predict the probability for the continuation of the current direction trend. Traders look for signals generated by the actions of the stochastic lines as viewed on the stochastic scale.
Stochastic - A Greek word meaning "guess" or "random" that in this context, refers to the task of predicting a future state based on past actions.
Oscillator - Repetitive actions that move (or oscillate) above and below an equilibrium.
STOCHASTIC OSCILLATOR BASICS
The Stochastic Oscillator consists of two lines - when both lines are included on a price chart, it is referred to as the Full Stochastic. The two lines are:
%K - tracks the current market rate for the currency pair
%D - "smoothes out" the %K line by calculating and plotting the exchange rate as a moving average - this is also known as the signal line
Trading platforms perform the calculation based on this formula:
%K = 100 x (Closing Price - Lowest Price of N Periods)
(Highest Price of N Periods - Lowest Price of N Periods)
Note that N is usually is set to 14 periods as this represents a large enough sample of data to arrive at a meaningful calculation.
Most systems allow you to modify the number of reporting periods but by doing this, you could alter the effectiveness of the results.
%D = 3 – Period Moving Average of %K
The calculation to create the %D Stochastic uses the last three valuations of %K to create a three-period moving average of the %K Stochastic. The result is a "smoothed-out" version of %K.
Because %D is a moving average of %K, it is referred to as "Stochastic Slow" as it reacts more slowly to market price changes than %K. As you would expect, %K is also known as "Stochastic Fast".