THE STOCHASTIC GROUP OF INDICATORS

Stochastic analysis is a general term describing a process of sampling random data to
generate information. In evaluating price action and in forex, the stochastic group of
indicators has the goal of providing insight into whether the price has lost its ability to close at the highest or lowest level. In simple terms, when a currency pair is strong, one
aspect of this strength is that it achieves closes that are higher. At some point, it loses
its strength and creates closes away from the top or bottom. The formula shows that
the stochastic compares the most recent closing price with the low of a preset period
of periods (14) and compares it against the high of the same period. The result is the
equation called %K:

%K = 100[(C − L14)/(H14 − L14)]

Then the stochastic indicator creates a moving average of the %K this is called %D.
A three-period moving average is usually used. A crossover effect is generated when the
%K line crosses the %D line.

Once again, a technical indicator is trying to smooth out the data to show something
of value. A high %K, for example, of 81 means that the price closing is percentage-wise
81 percent of the range of the period measured. So the ability of the price to stay that
high will be more difficult.
Stochastics, like any indicator, are not predicting anything. They provide a useful
measure of the power of the trend. There are several variations of stochastic indicators.
Most common are slow stochastics and fast stochastics. The difference is that slow
stochastics are less sensitive to price movements and therefore provide less risk of too
many crosses. The settings for the stochastic indicator are usually defaulted at 14 periods,
and 3 for the moving averages. Adjusting the settings to a smaller period of time,
such as 8 or even 5 periods, can provide more sensitivity to changes.
The use of the stochastics as supporting a trading decision can be seen in
Figure 12.11. If a trader were looking for a buy or sell entry and saw that the stochastic
indicator crossed (in the direction of the trade), it would be a green light to buy. If
it did not cross, then further confirmation would be necessary. The stochastic indicator acts like a traffic signal. It’s always necessary to watch all the traffic, but if the indicator
has crossed, then the trader could be focused on pulling the trigger.
The following section explains how the stochastic formula was calculated in more
detail (adapted from http://help.geckosoftware.com/40manual/new/use indicators/fsto/
faststo.htm).
Calculation
Parameters:
Overall Period (3)—the number of periods used to determine the highest high and
lowest low.
%D MA Period (14)—the number of periods used to determine the moving average
for the %D value.
Formula:
The first step in computing the stochastic indicator is to determine the n period high and
low. For example, suppose you specified 20 periods for the stochastic. Determine the
highest high and lowest low during the last 20 trading intervals. It determines the trading
range for that time period. The trading range changes on a continuous basis.
The calculations for the %K are as follows:
%Kt = ((Closet − Lown)/(Highn − Lown)) ∗ 100
%Kt: The value for the first %K for the current time period.
Closet: The closing price for the current period.
Lown: The lowest low during the n periods.
Highn: The highest high during the n time periods.
n: The value you specify.
Once you obtain the %K value, you start computing the %D value which is an accumulative
moving average. Since the %D is a moving average of a moving average, it requires
several trading intervals before the values are calculated properly. For example, if you
specify a 20-period stochastic, the software system requires 26 trading intervals before it
can calculate valid %K and %D values. The formula for the %D is:
%DT = ((%DT − 1 ∗ 2) + %Kt)/3
%DT: The value for %D in the current period.
%DT – 1: The value for %D in the previous period.
%Kt: The value for %K in the current period.




By ABE COFNAS