Of the several technical indicators used to indicate the relative overbought/oversold state of a market, I prefer the Stochastic Oscillator – although I use it in a rather unconventional manner. Before I tell you what I do with the Stochastic Oscillator let’s explore how the conventional oscillator is calculated and used.

The classic Stochastic Oscillator consists of two calculations – Percent K and Percent D.

The formula for the Stochastic Oscillator is as follows:

%K = Close – LL / HH – LL * 100

That is (close minus Lowest Low) divided by (Highest High minus Lowest Low).

Close is the current price.

Lowest Low is the lowest price for the past number of %K periods.

Highest High is the highest price for the past number of %K periods.

Stochastic Oscillator then displays the current price relative to the range of prices over the number of periods specified for %K – the number used in our example is 14

The range of the %K is from zero to 100. High values are overbought and low values are oversold. A value of 80 or greater is considered high and a value of 20 is considered low.

Obviously, a very high or very low, value over a very long number of periods, indicates the degree of overbought or oversold is extreme.

A smoothing factor is often used in percent K calculations. The calculation without additional smoothing is often called the fast Stochastic and the one with smoothing is often referred to as the slow Stochastic. Smoothing is using a short period average rather than the actual period figure.

Percent D, often referred to as the signal line, is a moving average of percent K and can be calculated in many different ways – with or without smoothing.

Figure 1 US Bond 6000 Ticks Per Bar, Fast Stochastic with 14 %K periods, smoothing factor of 1.

In the chart shown in Figure 1, percent K (the solid red line) is shown reversing its direction and crossing its signal line (percent D, the dotted yellow line). This is classically considered a buy or sell signal depending on whether the change in direction is up or down.

Note the potential trades market by the white vertical lines on the above chart. Each could have been a pretty good trade based solely on the Stochastic Oscillator.

However, look at all the other signals from the same indicator (whenever the red line crosses the dotted yellow line). Taking every one of these trades from the Stochastic Oscillator would have resulted in a small net loss – made even greater by the many sales commissions.

Nevertheless, I like the Stochastic Oscillator very much – it is my primary overbought/oversold indicator – but with a lot of modifications from the conventional usage.

What I seek is a way to get the few good signals – and eliminate the many mediocre signals and the few really bad signals.

My next post will cover our specific modifications to the Stochastic Oscillator- and how I use the indicator in my trading method.