The Stochastic indicator was developed in the 1950s by Dr. George Lane. The term Stochastic refers to the point of current price in relation to a PRICE RANGE over a PERIOD OF TIME. This is an attempt at predicting turning points thru comparing the closing price to the trade range.
I will repeat something specific here: “This is an attempt to predict turning points thru comparing the closing price to the TRADE RANGE.” The Stochastic is a RANGE BASED calculation. The 100 on the scale represents the HIGHEST HIGH in the last n periods. The 0 on the scale represent the LOWEST LOW in the last n periods. The current CLOSE is calculated in relationship to this range in an attempt to provide you with information regarding price movement.
%K is the range calculation and it simply is:
%K = 100 * (Price – Ln) / (Hn – Ln)
n = time period
H = Highest High in the time period
L = Lowest Low in the time period
If we were examining a 21 day range. The calculation would read.
100 * (Current Price – Lowest Low in last 21 day) / (Highest High in last 21 days – Lowest Low in the last 21 days)
%D is the moving average of %K over the same time period (or may have the ability to be adjusted).
The more modern approach is allowing you to adjust %D and add a smoothing value to the equation. If you return to the root equation and method. It stops being clunky – yet, an slight adjustment for faster and further moving markets also needs to be provided.
In the May/June 1984 edition of Stocks and Commodities magazine, Mr Lane published an article entitled “Lane’s Stochastics”. In this article Mr. Lane wrote the following: “In our research, our indicators were running all over the page, so we developed the technique of expressing them as a percentage of 100.
“We developed %A, found it didn’t work. We went on to research and to follow 28 oscillators. As we progressed through the oscillators we were developing, we expressed them as percentages as well; thus: %D, %K, %R.
“Larry Williams has taken our %R and refined it, improved it, and made it one of the more successful trend methods.”
I have found it interesting that this was how the naming came about. However, the labeling of “stochastic” came about because of the inability to name it %K in a computer program. So the developer of the program took the title “Stochastic”.
To continue to quote the article: (Pray that I don’t get scolded).
“This method is based on the observation that as price decreases, the daily closes tend to accumulate every closer to their extreme lows of the daily range. Conversely, as price increases, the daily closes tend to accumulate ever closer to the extreme highs of the daily range.”
Lane suggests that %D is a 3 period MA of the %K. In doing so, he states: “In working with %D it is important to remember that there is only ONE valid signal. That signal is a divergence between %D and the stock with which you are working.”
Lane in the article defined what he meant by DIVERGENCE. “As previously stated, this is the only signal which will cause you to buy or sell. Briefly stated, when a stock has made a high, then reacts, and subsequently goes to a higher high, while the corresponding peaks on the %D make a high then a lower high, a BEARISH divergence has been indicated. A sell signal is upon you.
“Conversely, when a stock has made a low, then rallies and subsequently moves down to a lower low, while the corresponding low points of %D have made a low, and then a higher low, you have a BULLISH divergence.”
Lane spoke of crossovers between the %K and %D. In mentioning this, he stated that a right-hand crossover is the most desirable. A right-hand crossover is where the %K crosses the %D AFTER the %D has already made the turn in the opposite direction. The crossing then appears AFTER the lowest point of the turn.
Lane also provided instructions to identify quickly possible reversals (short and long term). He called it a “Hinge”. It is basically where the plotted line is no longer straight and juts at various degree to one side. Of such he stated “A reduction in velocity of movement in either ‘K’ or ‘D’ indicating a reverse of trend the next day”. Of this “reverse of trend” is not a FULL reverse of trend. It could signal profit taking from a run.
“When the ‘K’ line has been declining each day and then one day reverses sharply (from 2% – 12%) this is a warning that you only have one or two more days of downward movement before a reversal.” And the same works conversely. This was a signal from the stochastic of a possible FULL trend reversal in the making.
One last piece of information from the author before I discuss changes to the Stochastic.
“There is another form of divergence. The primary function of this signal is to forewarn of a coming top or bottom. If a corresponding low is made on a stock and on %D and then a swing to the upside occurs; IF on the sell-off the correction of the stock is normal (in proportion making a higher bottom) but %D fails to new lows exceeding its prior low – a bear divergence set-up is signified. This means that the next swing up will probably provide an important top. The reverse of this holds true for tops.”
What does Lane have to say about the above 70, below 30 overbought/oversold sections? Absolutely NOTHING.
What he does say is the following: “When the ‘K’ line declines to a value of ‘0’ this DOES NOT denote an absolute bottom on the stock. On the contrary, it signifies a pronounced weakness. IMPORTANT: After ‘K’ initially reaches ‘0’ it will rebound, usually to about 20% – 25% and then come back toward ‘0’. It may not always reach ‘0’ the second time, but should at least come close. (Your experience and observation will indicate closeness to you.) Normally, it will take from 2 days to 5 days for ‘K’ to come back this second time, depending on the velocity of the issue which you are working…the reverse of these rules apply at tops using 100%. As in the case of the low, expect a sell-off or correction after the second attempt at 100% by the ‘K’ line. IT MUST BE REMEMBERED that 100% DOES NOT MEAN that the stock is as high as it can go, nor does 0% mean that we have reached the culmination of the downward move – in fact, they mean just the opposite.”
Modern stochastic indicators have adjustable horizontal lines display “overbought/oversold”. As previously stated the indicator DOES NOT determine overbought/oversold. So as such, I use them to help detect TREND zones.
In this particular example, I have the lines set at 63 and 37, the %K = 14 and %D = 3 (smoothing is set to 1 to remove the effect). While the %K is above the 63 it is telling me prices are in a BULL trend. When the %K is below 37 it is telling me prices are in a BEAR trend. Anything in between is neutral.
The faster the %K (ie, 5 vs 14) I close the levels closer. In the example of a 5 %K, the lines are both set at 50 and anything above 50 is BULL and below BEAR.
If I were to push the %K out, to say 210, I would then push the line back out. In that case, I would use a 70/30 to help detect trend.
In summary, we have examined from the original author his explanation and use of the indicator and I have provided some insight into the “zones”. instead of overbought/oversold.
All quotes are from Dr. George C. Lane in his article Lane’s Stochastics published in the May/June edition of Stocks & Commodities magazine. I do not own rights to this article. You can purchase of a copy of the article here from Stocks & Commodities.
Orion Price Prophet 
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