In the late 1950s, Dr. George Lane developed the stochastic oscillator – which is defined as a momentum indicator that utilizes support as well as resistance levels.
This indicator aims at predicting price turning points by comparing the closing price of a security to its price range. The sensitivity of the stochastic oscillator to market movements can be lessened by adjusting the time period or by taking a moving average of the result.
How is it calculated?
The stochastocs are calculated with the %K line and the % D line.
The formula for the indicator is:
%K = 100[(C – L14)/(H14 – L14)]
In the above formula,
C = the most recent closing price
L14 = the low of the 14 previous trading sessions
H14 = the highest price traded during the same 14-day period.
%D = 3-period moving average of %K
It should be kept in mind that the K line if the fastest and the D line is the slowest. %D line is the one that traders follow closely.
How it works?
The idea behind the stochastic indicator is when there is an upward-trending market, prices usually close near their high, while during a downward-trending market, the prices close near their low. The CEO of Wizard Trading, Jack D. Schwager uses the term “normalized” for such stochastic oscillators that have predetermined boundaries, both on high as well as low sides. Relative Strength Index or RSI is one such example of stochastic oscillator.
Developer of the indicator, Lane, had said in an interview that 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.”