Stochastic Oscillator

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Introduction

The basic premise of trading is to figure out where prices have been and then anticipate where prices are going. George Lane used this idea to develop the stochastic oscillator. Lane believed that that by monitoring price momentum, one could anticipate where prices were headed. The stochastic oscillator is a tool that allows traders to identify overbought, oversold price movements and to predict the direction of the trend.

Calculation

Where:
H is the highest price over the last n periods.
And L is the lowest price over the last n periods.

The formula compares a stock’s closing price to its price range over a given time period. The default time period used by most traders is 14. Sensitivity of the stochastic indicator can be adjusted by shortening or lengthening the time period. The idea behind the stochastic indicator is that prices tend to close near their high in an upward-trending market, and prices tend to close near their low in a downward-trending market. Buy and sell signals occur when the %K line crosses over the %D. The %D line is the 3 period moving average of the %K line.

There are three versions of the stochastic oscillator with the original formula called the fast version, and the other two called the slow and full. The additional versions were designed to smooth the oscillator and remove some of the randomness. The slow and full stochastics smooth the data that is used to calculate the fast stochastic. The slow stochastic is widely considered the most reliable of the three indicators.

Slow Stochastic:

Slow % K = 3 period moving average of the % K fast
Slow % D= N period moving average of the Slow % K

Full Stochastic:

Full % K = N period moving average of the % K fast
Full % D= N period moving average of the % K full

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Overbought Signals

 Stochastic Oscillator

As with most indicators, trades should always be taken in the direction of the primary trend to ensure the highest probability of success. In the above chart of ACW we see that from early February to mid April that prices are in 2 month down trend. Traders using the slow stochastic would have been able to avoid selling at short term bottoms in late February and mid March as the oscillator signalled oversold conditions. Astute traders would have traded in the direction of the trend by shorting ACW in early April.

Oversold Signal

Stochastic oversold signals should be used to add long positions during pullback in prices during up trends. In the daily chart of Cerner Corp we see the uptrend clearly defined as prices are trading above both the 50 and 200 day simple moving averages. High probability trades would be to add long positions on pullbacks or pauses in the uptrend. The red arrows identify overbought conditions signalled by the stochastic oscillator.

Stochastic Oscillator

Divergence

Divergence in direction of the stochastic oscillator and direction of prices on the daily chart provide strong indication that the prevailing trend is about to change.

Stochastic Oscillator
 

In the daily chart of Abbot Laboratories, we see in December of last year that prices have made a series of higher lows suggesting that ABT was in an uptrend. Traders who were watching the slow stochastic would have noticed that even though price was making higher lows that momentum was slowing. This was signalled by stochastic lines making lower lowers. This divergence right before price of ABT traded 47.50 to 44.50 in only four trading sessions.

Stochastic Oscillator
 

In the weekly chart of the Dow Jones Industrial Average we see that in the last quarter of 2009 prices continued to make lower lows. In the meantime the stochastic line was making higher highs signalling that the down trend was about to come to an end. The INDU index proceeded to bottom in March of 2009 at 6500 and trade up to 12500 in the next 2 and half years.

Stochastic Pop

Stochastic Oscillator

One of the biggest mistakes made by novice traders is to take contra trend positions when oscillators move into extreme readings. In the above chart of Exxon Mobil we see that oscillators can remain in extreme readings for extended periods of time. Many traders refer to this as a “stochastic pop”. Prices “pop” out of a consolidation range and begin a new trend. If the trend is strong enough we can see the stochastic oscillator have extreme readings for long periods of time.

In November of 2010 XOM was trading sideways between 68 and 71 dollars. In December XOM broke out to the upside when prices closed about 71. Exxon Mobile went on to trade from 71 to 88 in the next four months. We see that in this entire four month period that the stochastic oscillator was overbought. The stochastic pop is a good reminder for traders to always to trade in the direction of the primary trend.

Conclusion

The stochastic oscillator is an excellent tool to identify overbought and oversold trading conditions. Like the majority of technical indicators and overlays, they should never be used in isolation to make trading decisions. Trader will find that they will have the greatest success when using oscillators in conjunction with other indicators. One thing that will forever be true is that price is always the final arbiter and those traders who ignore this do so at their own peril.