Trading stochastics

A simple leading technical oscillator found on nearly all charting software packages can be a key to providing confirmation
trading signals.

The Stochastic Oscillator was created by George C. Lane and introduced in the late 1950s. The Stochastic indicator is a momentum and leading indicator, which gives you a reversal signal in price momentum near important turning points allowing you to enter the market with great accuracy for bigger profits. 

Leading indicators are those created to precede the price movements of a security giving predictive qualities.
It was one of the first technical indicators used by analysts to provide insight into potential future market direction. The Stochastic Oscillator is plotted within a range of 0 and 100 and signals overbought conditions above 80 and oversold conditions below 20. The stochastic oscillator contains two lines. The first line is the %K, which is essentially the raw measure used to formulate the idea of momentum behind the oscillator. The second line is the %D, which is simply a moving average of the %K. The %D line is considered to be the more important of the two lines as it produces better signals.

According to an interview with Lane, the Stochastic Oscillator “does not follow price, it does not follow volume or anything like that. It follows the speed or the momentum of price. As a rule, the momentum changes direction before price.”

Calculation

The stochastic oscillator is calculated as a percentage of a security’s closing price to its price range over a given time period. This indicator is calculated with the following formula: 

%K = 100[(C - L14)/(H14 - L14)] 

Whereas: 

C = the last traded price at closing,

L14 = the lowest traded price in previous 14 trading sessions,

H14 = the highest traded price in last 14 day sessions, and

%D = 3-period moving average of %K (it acts as a trigger line).

The default setting for the Stochastic Oscillator is 14 periods, which can be calculated on hourly, daily, weekly and monthly charts.

The Stochastic Oscillator can be further categorized into three types:  Fast Stochastic Oscillator, slow Stochastic Oscillator and a full Stochastic Oscillator.

Fast Stochastic Oscillator: The Fast Stochastic Oscillator is based on original formulas for %K and %D. As per Lane, %D divergence is the “only signal that will cause you to buy or sell.”

The Fast Stochastic plots two lines — one solid and one dotted — in its indicator panel. The two lines are called the %K line and the %D line. The inputs to Stochastic Fast are as follows: 

Fast %K:   [(Close - Low) / (High - Low)] x 100 

Fast % D:  3-period SMA of Fast %K 

Slow Stochastic Oscillator: Because of the Fast Stochastic version’s tendency to create whipsaws, traders developed the Slow Stochastic version which smoothes out the data used in the original. The Slow Stochastic Oscillator smoothes %K with a three-day simple moving average (SMA), which is exactly what %D is in the Fast Stochastic Oscillator. 

Calculation for Slow Stochastic Oscillator:

Slow %K = Equal to Fast %D (i.e., 3-period moving average of Fast %K) 

Slow %D = 3-period SMA of Slow %K

Notice that %K in the Slow Stochastic Oscillator equals %D in the Fast Stochastic Oscillator (see “Oscillating oscillators,” right). The Slow Stochastic creates less false signal due to the smoothing effects of the moving averages.

The comparison of the slow and fast Stochastic Oscillator in Apple (AAPL) shows:

Slow Stochastic gives less false signal when compared to Fast Stochastic as shown in above chart. 

Circles are marked where Fast Stochastic is giving false signals but that gets smoothed because of moving averages in Slow Stochastic.

The Stochastic Oscillator can be used to generate buy and sell signals three ways: Extreme values (overbought/oversold), stochastic crossovers and stochastic divergences. 

Extreme Values (overbought/oversold): The stochastic oscillator is plotted within a range of 0 and 100, and signals overbought conditions on an underlying market when it is above 80 and oversold conditions when it is below 20. Buy when Stochastics move above the 20-line and sell when Stochastics move below 80-line.

“Trade signals” (below), shows the Stochastics gave a buy signal in Citigroup (C) as it moved above 20 on Nov. 4, 2016, while also forming a Doji candlestick suggesting an impending reversal. The next day Citi gapped up and traders could go long around $49, with a stop placed at the previous day’s low of $47.50, and ride the move until the Stochastics becomes overbought. Citigroup rallied all the way to $57 when Stochastic became overbought. 

It is important to note that overbought/oversold readings alone are not necessarily entry signals. Securities can become overbought or oversold and remain that way for an extended period. It is best to use overbought/oversold readings along with another technical indicator as a confirmation of a move; like the Doji signal in “Trade Signals.” 

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