The Stochastics Oscillator is a technical momentum indicator
that compares a security's closing price to its price range over a given time
period, usually 14 periods. (1 period = 1 day for this example) This
indicator is calculated with the following formula:
%K = 100[(C  L14)/(H14  L14)]
%D = Smoothed, 3 day simple moving average of %K
C = the most recent closing price
L14 = the low of the 14 previous
trading sessions
H14 = the highest price traded during the same 14day period
As an example, below is a table of daily highs, lows and
closing prices for a particular index over 14 trading days. On day 14, %K
would be calculated as shown below where C=115.38, L14=109.13, and H14=119.94.
%K for trading day 14 where the index closed at 115.38 equals
57.81. This tells us that the index closed in the 58th percentile of the
14 day high/low range, or just above the midpoint. Because %K is a ratio,
it will fluctuate between 0 and 100. A smoothed, 3day simple moving
average of %K is then plotted alongside to act as a trigger line, called %D.
Below is an example of a daily chart of IBM and its respective
Stochastics Oscillator, courtesy of StockCharts.com. One of the more
conventional and accurate ways to leverage this indicator is to indentify
overbought and oversold situations by looking for divergences. For
example, the stochastic oscillator produced 2 solid signals for IBM between
Aug99 and Mar00. In Nov99, a buy signal was given when the indicator
formed a positive divergence and moved above 20 for the second time. Note
that the double top in NovDec (gray circle) was not a negative divergence, and
thus the stock continued higher after this formed. In Jan00, a sell
signal was given when a negative divergence formed and the indicator dipped
below 80 for the second time.
