Stochastic oscillators are momentum indicators that compare the closing price of a security to a range of its prices over time. There are both fast and slow stochastics.
The main difference between fast and slow stochastics is their level of sensitivity. The fast stochastic is more sensitive than the slow stochastic to changes in the price of the underlying security and will likely result in many transaction signals. This sensitivity can be useful to traders, but it can also result in false signals. Using both types of stochastics can help provide more useful, balanced investment information.
Key Takeaways
- Stochastic oscillators are momentum indicators comparing a closing price of a security to a range of its prices over a certain period of time.
- The sensitivity of the oscillator to market movements is related directly to the length of that time period or by taking a moving average of the result.
- The “fast” stochastic uses the most recent price data, while the “slow” stochastic uses a moving average.
- The fast version will react more quickly with timely signals but may also produce false signals.
- The slow version will be smoother, taking more time to produce signals, but may be more accurate.
What Are Stochastics?
The word “stochastic” indicates some sort of random process. This randomness can be measured probabilistically but cannot be known completely in advance. Adding randomness, or “noise,” to understanding the movement of stock prices was seen as a major innovation.
The stochastic oscillator was developed in the late 1950s by George Lane. As designed by Lane, the stochastic oscillator presents the location of the closing price of a stock in relation to the high and low range of the price of a stock over a set time, typically 14 days. Lane designed the stochastic oscillator to follow the speed or momentum of price changes, rather than price or volume.
Lane also revealed in interviews that, as a rule, the momentum or speed of the price of a stock changes before the price changes itself. In this way, the stochastic oscillator can be used to foreshadow reversals when the indicator reveals bullish or bearish divergences. This signal is the first, and arguably the most important, trading signal Lane identified.
How the Stochastic Momentum Oscillator Works
Developed as a tool for technical analysis, the stochastic momentum oscillator is used to compare where a security’s price closed relative to its price range over a given period of time, usually 14 days. It is calculated using the following formula:
%K=(H14−L14)100∗(CP−L14)where:C=Most recent closing priceL14=Low of the 14 previous trading sessionsH14=Highest price traded during the same 14-day period
A %K result of 80 is interpreted to mean that the price of the security closed above 80% of all prior closing prices that have occurred over the past 14 days. The main assumption is that a security’s price will trade at the top of the range in a major uptrend. A three-period moving average of the %K called %D is usually included to act as a signal line. Transaction signals are usually made when the %K crosses through the %D.
Generally, a period of 14 days is used in the above calculation, but this period is often modified by traders to make this indicator more or less sensitive to movements in the price of the underlying asset.
Fast vs. Slow
The “speed” of a stochastic oscillator refers to the settings used for the %D and %K inputs. The result obtained from applying the formula above is known as the fast stochastic. Some traders find that this indicator is too responsive to price changes, which ultimately leads to being taken out of positions prematurely. To solve this problem, the slow stochastic was invented by applying a three-period moving average to the %K of the fast calculation.
The fast stochastic uses the formula above, where %D is a three-day moving average of %K. The slow stochastic replaces %K with the Fast %D (the moving average of the fast %K) and replaces %D with a moving average of slow %K.
Taking a three-period moving average of the fast stochastics %K has proved to be an effective way to increase the quality of transaction signals; it also reduces the number of false crossovers.
After the first moving average is applied to the fast stochastics %K, an additional three-period moving average is then applied, making what is known as the slow stochastics %D. Close inspection will reveal that the %K of the slow stochastic is the same as the %D (signal line) on the fast stochastic.
Is the Stochastic a Leading or Lagging Indicator?
Both fast and slow stochastic oscillators are used to show when a security’s price may be coming up on a reversal. Because of this, they are seen as leading indicators, even though the data they use is historical.
What Are %K and %D of a Stochastic?
For a stochastic oscillator, %K is the current price of the security, shown as a percentage of the difference between its highest and lowest point over the time the oscillator is being used. %D is a 3-day average of %K. This shows whether the current trend is continuing or changing.
What’s the Main Difference Between Fast and Slow Stochastics?
The primary difference between fast and slow stochastic oscillators is sensitivity. Fast stochastics are more sensitive to changes in price and produce many more signals. However, this frequency can result in excess noise and false signals. Slow stochastics use a moving average, which is less sensitive to changes. This creates fewer signals for traders to use, but these signals are more likely to be reliable.
The Bottom Line
Both fast and slow stochastics are oscillators that look at the momentum of price changes for a given security. The fast stochastic is agile and changes direction quickly in response to sudden changes. The slow stochastic changes direction more slowly but is less likely to give false signals.
Mathematically, the two oscillators are nearly the same except that the slow stochastics %K is created by taking a three-period average of the fast stochastics %K. Taking a three-period moving average of each %K will result in the line that is used for a signal.