The main difference between fast and slow stochastics is summed up in one word: 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. However, to really understand this difference, you should first understand what the stochastic momentum indicator is all about.
- Stochastic oscillators are a class of momentum indicators comparing a particular 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.
- Therefore, 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.
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 period of time, typically a 14-day period. Lane, over the course of numerous interviews, said that the stochastic oscillator does not follow price or volume or anything similar. He indicated that the oscillator follows the speed or momentum of price.
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 sessions
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.
- Fast= the formula spelled out above, where %D is a 3-day moving average of %K.
- Slow= replace %K with the Fast %D (i.e. the MA of the fast %K); replace %D with a MA 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.
The Bottom Line
An easy way to remember the difference between the two technical indicators is to think of the fast stochastic as a sports car and the slow stochastic as a limousine. Like a sports car, the fast stochastic is agile and changes direction very quickly in response to sudden changes. The slow stochastic takes a little more time to change direction but promises a very smooth ride.
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.