Stochastic Oscillators

The stochastic concept is based on the findings that the daily highs are approached by the closing prices under the conditions of an up forex market; on the other hand, under the conditions of a down market, the closing prices tend to reach the daily lows. Those observations are very useful to forex traders since they give signals to them even before they are reflected in the price of the currency.

Stochastic oscillators are technical momentum indicators that compare the closing price of a currency to its price range over a certain period of time.

Two lines are included in the stochastic oscillator - the %K and %D. To better understand them, imagine the %K as the plotted instrument, whereas the %D as the moving average.

Stochastic Oscillator Formula

In order to calculate the stochastic indicator traders should apply the following formula:

%K = [(CCP - LOWn) / (HIGHn - LOWn)]*100

Where:

CCP - current closing price

LOWn - the lowest low for the previous n trade periods

HIGHn - the highest high for the previous n trade periods

Typically n=14 but this may vary. When the CCP is the lowest for the last n trade periods, the %K value is 0. On the other hand, when the CCP is a highest for the last n trade periods, the %K value is 100.

%D = SMAn %K

Where:

SMAn - simple moving average across n periods; typically n=3

A scale from 1 to 100 is used to plot the results from the calculations of the formulas above.

Stochastic Oscillator Indications

If the result is 70%, then traders get a warning indication of overbought conditions. On the other hand, if the result is 30%, then traders get a warning indication of oversold conditions. Additionally, if the value is under 10%, forex traders should interpret it as a signal to buy, meaning that bullish reversal is about to occur. Alternatively, if the value is above 90%, then traders should interpret it as a signal to sell, meaning that bearish reversal is about to be experienced.

Further trading signals are generated when the %D and %K cross each other. Generally, two types of crossings between the %D and %K can be observed - left and right crossing.

Larry Williams Percent Rate (Williams's %R)

A version of the stochastic oscillator is the Larry Williams percent rate, which is also known as Williams's %R.

In order to calculate this rate, the current close price should be subtracted from the highest high price for a specific number of days and then the result should be divided by the total range.

A reversed scale from 0 to 100% is used for plotting the Williams's %R oscillator. A result of less than 80% signals a bullish reversal. On the other hand, a result that is more than 20% indicates bearish conditions.

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