Stochastics work best with those securities that are currently trading within a particular range and may prove useful in identifying buying and selling points. But they can return false signals, especially during periods when stocks are in a strong uptrend or downtrend. | TECHNICAL ANALYSIS uSINGTHESTOCHASTICOSCILLATOR By Wayne A. Thorp Stochastics work best with those securities that are currently trading within a particular range and may prove useful in identifying buying and selling points. But they can return false signals especially during periods when stocks are in a strong uptrend or downtrend. There is no such thing as a universal indicator. Rather different conditions dictate the use of different indicators. Oscillators which are indicators that move between zero and 100 are useful in identifying conditions where a security may be overextended overbought or oversold. In the May issue of the AAII Journal we took a look at one popular oscillator Wilder s relative strength index. This article focuses on another popular indicator the stochastic oscillator. THE CALCULATION The word stochastic is defined in general as a process involving a random variable. The stochastic oscillator was first introduced by George Lane in the 1970s. This indicator consists of two lines the K and D lines and compares the most recent closing price of a security to the price range in which it traded over a specified time period. The following formula shows you how to calculate the latest point on the K line K Close - Lo - Hi - Lo x 100 Where Close Last closing price Hi Highest intraday price over the designated period Lo Lowest intraday price over the designated period Therefore if you were calculating a five-day K line the first point would be calculated using the highest price over the last five trading days and the lowest price over the last five trading days as well as the closing price for day five the last day of the five-day period . The D line typically is a three-point moving average of the K line and serves as a trigger line for generating trading signals. In other words you add together the last three K values divide this sum by three and continue this over a rolling three-day period. You can use any type of moving average you wish when .
