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Stochastics Oscillator

Definition:
The Stochastics oscillator, a popular and dynamic indicator developed by Dr. George Lane, is based on the premise that during an upward trading market, prices tend to close near their high, and during a downward trading market, prices tend to close near their low. Stochastics measures at what point the price of a security is within the entire price range of the security over a given period.

The stochastics indicator is plotted as two lines, %K and %D. The range of the Stochastics is between 0 and 100. With a price range of ten to twenty, ten would be given a 0 designation, fifteen would be at 50, and a price of twenty would be at the 100th percentile. The values of the stochastics calculations are dependent on the parameters given to %K and %D.

There are two types of stochastics: fast stochastics and slow stochastics. When calculating fast stochastics, the raw value of %K is the point at which the current price lies within the historical price range of its given period, and the value of %D is the moving average of %K over a given number of periods.

When calculating slow stochastics, the value of %K slow is the %D-period moving average of the point at which the current price lies within the historical price range of its given period (or raw %K), and the value of %D slow is the moving average of the %K slow over a given number of periods.

IQ Chart and IQC.COM use slow stochastics, which by being smoothed, tend to exhibit less market noise.

An oscillator refers to a momentum or rate-of-change indicator that is usually valued from -1 to +1 or 0% to %100.

Interpretation:
There are several major interpretations for stochastics, which may be more beneficial when combined with other indicators that discern whether a market is in a trending or cyclical rotation mode.

One interpretation (and the one Dr. Lane believes to be most important) is to look for a divergence between %D and the price. An overbought market occurs when %D makes a series of lower highs while the price makes a series of higher highs. An oversold market occurs when the price makes a series of lower lows while %D makes a series of higher lows.

A second interpretation is to receive signals based on a crossover of the two lines. When the %K line rises above the %D line it is considered bullish, and when the %K line falls below the %D line, it is considered bearish. You can eliminate some false signals by using only the signals which correspond to the direction of the intermediate to long term trends.

A third interpretation is that a buy signal is generated when either line dips below and then rises above 20, and a bearish signal is generated when either line rises above and then dips below 80.

Many investors combine several of these interpretations as a major criterion used for making trading decisions.

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