TAI - Lane’s Stochastic Oscillator (LSTOCH)

Name, Sometimes Called:

Lane’s Stochastic Oscillator
Sometimes simply called Stochastics
Variations include fast, slow and full stochastics.

Brief Description:

Stochastics is a two line, price-based oscillator that ranges between zero and 100. It occurs in three variations with respect to smoothing and interpretation of overbought and oversold levels. This technical analysis indicator can be used to determine entry and exit points. The indicator can be highly volatile with a potential for damaging whipsaws.

Definitions, Formulas:

To calculate Lane’s Stochastics, first determine n, the number of periods to be covered. George Lane, who created this indicator, suggests between 5 to 21 days.

Then calculate K, the current price relative to the recent range of prices

K = 100 x ((C – L(n) / (H(n) – L(n))

where

C = the latest closing price
L(n) = the n-period low
H(n) = the n-period high

Next, calculate

%K = SMA(3)(K)

and

%D = SMA(3)(%K)

%D is a three period simple moving average (SMA) of %K as the signal (sometimes called the trigger) line.

To make this more concrete, we will use General Electric as an example with n= 8, and the period between December 1 and 10 of 2003.

After the market close on 10 December 2003, of the past 8 days, the highest high was on 9 December 2003, at $29.81. The lowest low was on 1 December 2003 at $28.78. The most recent close in the period was $29.72.

%K = 100 x ( ( 29.72 – 28.78 ) / (29.81 – 28.78) )
%K = 100 x ( .94 / 1.03 )
%K = 91.26

Because the recent close can’t exceed the highest high (the highest the recent close can be is the highest high, but no higher), %K must range between zero and 100.

If we interpret the results for 10 December 2003 in words, we would say, “29.72 is above the 90th percentile of the trading range (with a low of 28.78 and a high of 29.81) over the past 8 periods.”

“Fast” vs. “Slow” Stochastics
In the example above, the value for %K was computed and presented based only on today’s closing price. When plotted, this can result in a very jagged line that can cross and re-cross the %D signal line many times. This is the variation called “Fast Stochastics.”

To slow this rate of change, %K is presented not as a value based on today’s closing price, but as a simple moving average of the last three periods’ closing price. Because %D is a three-period simple moving average of %K, %D is now doubly smoothed, since %K itself is smoothed.

Fast Stochastics (n, d) where

n is the number of periods to evaluate
d is number of %K values to average to create %D and d = 1
In our example above we used Fast Stochastics (8,3)

Slow Stochastics (n, d) where

n is the number of periods
d is number of %K values to average to create %D and d = 3

So in slow Stochastics, the presented %K is really a three-period simple moving average of the daily computed %K.

“Full” Stochastics
“Full” Stochastics allows you to specify a third parameter, the smoothing factor for %K.

Full Stochastics (n, k, d) where

n is the number of periods to evaluate
k is the number of computed %K to average for the presented %K
d is number of %K values to average to create %D

The averaging method used in d above can be exponential, simple, triangular, variable, or weighted.

We use the Full Stochastics variation: Full Stochastics (n, k, d) where

n =10 periods
k = 3 for Full Stochastics
d = 3 Number of periods for smoothing of %D

The smoothing method is a simple moving average (SMA).

Stochastics and Divergence
One of the most reliable signals is to wait for a divergence to develop from overbought or oversold levels. Moving below 20 indicates %D is preparing for a positive development. Then we wait for a positive divergence, when the indicator moves higher as the price declines. The first break above 20 may be short lived and %D may decline below 20 rapidly. The second break may be longer lived.

Positive Development Calculation:

There are two ways a single new positive development (NPD) can be generated using the Stochastic technical analysis indicator (TAI):

a) when %K crosses over %D (%K x+ %D) (potentially volatile leading to whipsaws), or

b) when the %D indicator rises from the below 20 oversold level and there is a positive divergence.

Similarly, there are two ways the positive development becomes no longer positive:

a) if the positive development was produced by case a) above, then it is no longer positive when %D rises above 75, or

b) if the PD was positive development was produced by case b) above, then it is no longer positive when %K x- %D.

If this TAI is still positive tomorrow, it will no longer be new, but will be a cumulative positive development (CPD).

If this TAI was a new positive development (NPD) yesterday, and is still positive today, then it becomes a cumulative positive development (CPD).

History:

In the late 1950s, Dr. George C. Lane postulated the theory that in a trending market, prices tend to close in the direction of the market. That is, in an upward trend, prices tend to close nearer the high and in a downward trend, prices tend to close nearer the low. A high frequency of closes near the top of the high indicates accumulation (buying). A high frequency of closes near the low indicates distribution (selling). Dr. Lane used a %K value over 80 to indicate an overbought condition and a %K value under 20 to indicate an oversold condition. Others prefer 75 and 25 to indicate these levels.

This chart shows Lane’s Stochastics indicator applied to Intel (INTC) March to April 2005. To the standard presentation we have used a differential histogram to clearly indicate the crossovers. When the histogram shows red bars and negative then %k is under %d. When the histogram shows green bars then %k is over %d.

Notice the crossover signal correctly anticipates the price rise. Then there is a pullback in the stock price. The Stochastics indicate a negative rapidly followed by a positive. These are whipsaw signals. The non-whipsaw signal follows a few days later.