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Stochastic Oscillator, Fast Stochastic, Slow Stochastic

The Stochastic Oscillator, a momentum indicator, was developed by George C. Lane in the late 1950s. He observed that when prices increase, closing prices tend to be closer to the upper end of the price range, and decreasing prices are marked by closing prices near the lower end of the range. It is composed of two lines, %K (raw data) and %D (moving average of %K), that oscillate between 0 and 100. It can give early indications of strength or weakness in the market.

A rising stochastic line indicates increasing price momentum, while a falling stochastic line indicates decreasing price momentum.

Readings below 20 are considered oversold and readings above 80 are considered overbought, however prices can remain in overbought or oversold territory for quite some time, so that does not necessarily generate specific action to buy or sell. Furthermore, prices can continue rising while in overbought territory and they can continue declining in oversold territory. However buying into an overbought market or selling into an oversold market entails above-average risk, especially when the overbought situation is near a resistance level or if the oversold situation is near a support level.

Buy signals are generated when the oscillator falls below 20 and then subsequently rises above 20, or when the %K line rises above the %D line. Sell signals are generated when the oscillator rises above 80 and then subsequently falls below 80, or when the %K line falls below the %D line.

Buy or sell signals are also generated by divergences. If price makes a new low without being confirmed by a corresponding lower low on the stochastic oscillator, it indicates market strength and possibly a buy signal. If price makes a new high without being confirmed by a corresponding higher high on the stochastic oscillator, it indicates market weakness and possibly a sell signal.

This indicator is most effective when prices are in a broad trading range or in a mild trend, but it is less effective in a strong trending market that has only minor corrections. In a strong trending market, the start of a reaction against the trend can give some false signals that should be ignored, however the crossover signal at the end of the reaction against the trend is more reliable.

This oscillator is calculated as follows:

%K = 100* ( (Rc - Ll(n))/(Hh(n) - Ll(n)) )
%D = 3-period moving average of %K

(n) = Number of periods used in calculation
Rc = Recent Close
Ll = Lowest Low
Hh = Highest High

Thus the Stochastic oscillator compares closing prices above the lowest range low, to the price range, over a specific period - based on George Lane's theory that prices tend to close near their high in an upwardly-trending market and prices tend to close near their low in a downwardly-trending market. As an upward trend gets closer to completion, price tends to close further below its high; and as a downward trend gets closer to completion, price tends to close further above its low, leading Lane to believe that these conditions can indicate the beginning of a trend reversal.

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