Stochastics of various sorts have a couple of roles in finance. Broadly, in probability theory ‘stochastic’ is synonymous with ‘random’ and a stochastic process is any process whereby a system’s state is determined by both the predictable functions of the process and a random element. A stochastic process is a sequence of random variables known as a time series.
Financial markets tend to use stochastic processes in order to model apparently random fluctuations in stock values, interest rates and currency exchange rates. Stochastics are also at the heart of the insurance industry, which is essentially based on a profound understanding of probability theory, and touched upon in risk management.
More specifically for technical analysis, however, stochastic oscillators are a technical momentum indicator, developed by George C Lane towards the end of the 1950s, comparing the closing price of securities to their total price range over a given trading period. The sensitivity of the oscillator to short-term market fluctuations can of course be adjusted by altering the time period covered or by taking an average of results in order to smooth out spikes.
The basic formula for calculating a stochastic oscillator is as follows. It’s worth noting that the default lookback setting on a stochastic oscillator is usually 14 days, changed here to 7 for purposes of simplification:
%K = 100[(C – L7)/(H7 – L7)]
C = the most recent closing price
L7 = the low of the 7 previous trading sessions
H7 = the highest price traded during the same week.
%D = 3-period moving average of %K
Although this %K function looks daunting at first, it is actually a fairly simple formula, and once it has been plotted against %D (a moving average of %K across three periods), a stochastic oscillator’s role is to indicate to investors when might be a good time to buy and sell. The theory runs than in an upward trending market, prices close near the top of their price range, while prices will close towards the bottom of the range in a downward trending market, which is intuitive. When the %K variable crosses through the %D then this is a transaction signal.
When interviewed about the stochastic oscillator, Lane later indicated that its usefulness was due to the fact that the function does not follow price, or volume. “It follows the speed or the momentum of price. As a rule, the momentum changes direction before price.” As such the stochastic oscillator can be used to foreshadow dramatic reversals in markets.
A stochastic oscillator is a useful tool for illustrating momentum in prices and market directions, but ultimately it is only an indicator of what has happened in the past, and investors must always use it only in conjunction with other technical analysis tools.