I wrote in my recent Trader's Corner article (9/20) about the Relative Strength Index or RSI, one type of momentum indicator, which also attempts to measure overbought/oversold conditions. To look at the other popular variations of this type of indicator, I will devote this column to Stochastics and another (column) to the MACD indicator.

I first made use of the Stochastic process indicator when I was trading commodity futures and getting 'killed' in a position prompted by a very bullish Merrill Lynch analyst. I thought something was missing here. Duh! There had to be some other method to use to suggest a more objective way to be on the right side of the market; one not wedded to a static view of the current market fundamentals. A trader friend asked if I knew about 'oscillators', specifically Stochastics. This technical model had him short and making money. Sounded good to me!

The central idea or concept of Stochastics, what its formula is all about, is the idea that in up or down market trend for any number of trading periods (e.g., 10 hours or 14 days), prices will at times move away from the lowest low or highest high during the period being looked at, at an INCREASING RATE. This rate or speed of price changes is what the (slow) stochastic indicator shows visually.

An indicator which has a formula such that its scale is between 0 and 100 only, like Stochastics or RSI, or, fluctuates in a familiar range like MACD, will tend to 'oscillate' back and forth between the low and high end of this fixed scale. Hence this class or type of indicators are called oscillators. Ones that have a range with 0 to 100 are 'normalized' to that scale and the RSI and Stochastics are of this type.

Oscillators are especially helpful to shorter-term traders, including of course many if not most options traders, although some are looking to trade the longer trends. When the indexes or a stock is confined to a trading range, then the Stochastic model is most useful as prices will tend to fluctuate in a certain range. The low end of the range will tend also to register at the low end of the oscillator scale (as oversold) and the high end of the price range will be in the overbought zone.

I'm going to have some examples from my (Essential Technical Analysis) book. These are not current charts but good in showing the principles of using stochastics in trading. Let me start however with a couple of current charts, reflecting some key index charts through Wednesday (9/23).

Wednesday's market action looked like a key downside reversal in terms of its price pattern, as the major indexes went to a new high, followed by a Close under the prior day's low, as seen below with the Nasdaq 100 (NDX) index:

Today's downside reversal occurred from an overbought area in the 14-day Stochastic model, using a common default setting for stochastic length. Moreover, there was a crossover sell 'signal' where the upper stochastic line crossed BELOW the lower slowing moving line as seen in the S&P 500 (SPX) daily chart. This is the second such 'signal' in recent days.

One problem with such a stochastic 'sell signal' is of course that we have no way of knowing if it (the crossover) will lead to another short-term correction only or if this is the start of something bigger. However, since the market is also overbought on a long-term weekly chart basis as I highlighted in my last Index Wrap (9/19) AND this particular downside stochastic crossover occurred along with a key reversal pattern, I am going to assume that yesterday's (Wednesday) action marks the start of a more significant pullback than the recent shallow ones. Stay tuned on that! Right or wrong, the point I want to make is that indicators are best used to 'confirm' or 'not confirm' chart patterns. This has to be so since indicators DERIVE from price.

STOCHASTIC CONCEPTS:

The concept of 'overbought' and 'oversold' is thought of relating to momentum indicators like Stochastics. Overbought or oversold should always be thought of in relation to what time frame is being considered. Traders are interested in short to intermediate-term reversal points and investors are primarily concerned about a situation where a market is at a possible overbought or oversold extreme on a long-term basis.

Overbought or oversold also relate to a potential vulnerability for a trend reversal. However, the market or a specific stock and can stay oversold or overbought for a relatively long period. It is also true that rapid and steep advances or declines are not sustainable for an unlimited period. A market will correct at some point after a steep rise or fall, but WHEN is an open question, especially in a strong trend as is true currently, when the market seems to only go up.

When I first used stochastics I had a tendency to think that the first time or two that this indicator reached an extreme reading, whether using an hourly, daily or a longer-term weekly chart, it must be time for me to exit any positions I had; and, even reverse positions. I learned of course that there were many instances where the trend momentum takes prices significantly higher or lower before there is a correction. Moreover, a 'correction' may just turn out to be a sideways consolidation period, before there is yet another push in the same direction as before.

Oscillators like Stochastics are 1.) especially useful in terms of timing trades that are consistent with the dominant trend; e.g., buying even minor oversold dips in an overall uptrend, shorting even minor overbought rallies in a dominant downtrend.

Stochastics are next most useful 2.) where an index or stock is experiencing two-sided price swings where highs and lows are made in the same area repeatedly. The stochastic will register overbought or oversold in those areas.

3.) Stochastics work third best to 'time' an intermediate trend reversal occurring within a strong major trend, either up or down. If price action also suggests a possible intermediate trend reversal, than the 'confirming' usefulness of a buy or sell stochastic 'signal' is increased.

THE STOCHASTICS FORMULA:

The Stochastics study attempts to highlight 'momentum' or trend strength and areas where a market may have reached at least an interim high or low. The 'stochastics process' (its first name) study was popularized by a trader named George Lane who was involved in the futures markets.

If I select Stochastics as a 'study' on my charting application, you can always edit 'length', sometimes also 'smoothing' of %K and 'smoothing' of something called '%D'. Length is the one you will most likely want to vary or play around with. You can set smoothing of percent (%) K to 1 so there is NO smoothing factor and leave the default setting for smoothing of percent (%)D at 3; this is the one that 'smoothes' out %K and that is the way this study was designed to be used. I may have lost you here, but I needed to touch on this.

The most common length setting, that is the period or number of hours, days or weeks that that the stochastics formula will 'reference', similar to the RSI, tends to be either 9 or 14-periods or bars. The stochastics default settings for what is the oversold and overbought levels or zones are typically pegged at 20 and below and 80 and above.

The stochastics indicator is composed of two lines: a slower line called the percent D (%D) line, which is a simple moving average of the faster %K line. As with the MACD, the two lines of varying speeds lead to crossovers that generate buy and sell signals so to speak.

The Stochastic model or formula looks at the current price in relation to the highest high or lowest low in the period being measured. Stochastics plots the current close in relation to the price range over the length set for this indicator and gives this a percentage value.

The initial calculations for a stochastic of 14-days are twofold, establishing a 'fast' and 'slow' line. The FAST line is called the percent K (%K) line and its formula is 100 minus (current Close minus the 14-day Low) divided by (the 14-day high minus the 14-day low).

The 'slow stochastics' variation of the basic stochastics formula is simply to apply a 'smoothing' calculation resulting in another line called 'SlowD'. The slow version of the stochastics oscillator (slow stochastics) is the version that is in most common use and is most likely what you will be using if you choose the stochastics indicator to apply to a price chart. Use of slow stochastics is the most appropriate for all around use.

If an upside or downside acceleration is especially strong, the two stochastic lines will reach a reading of 20 or below, or 80 and above, very quickly. In the overbought area at and above 80, the rate of price increase is thought to be too steep to be sustainable; e.g., above 80 representing an extreme that suggests that there is some likelihood that the market in question will correct by a sideways consolidation or a downward reaction.

At and below a reading of 20 in the slow stochastic indicator, indicates a steep rate of decline and is also considered to be unsustainable. The assumption here is that index or stock in question faces a significant likelihood of a correction; e.g., a sideways consolidation or upward reaction.

Buy and sell crossover signals are considered to be optimal if they occur in or near the overbought and oversold zones, respectively. There will be instances of crossovers that occur in the middle of these ranges and these should not be utilized unless there is compelling other technical considerations that are guiding you – for example, a break out above or below an important trendline. Again, an historical chart:

The most frequent use made of the stochastics indicator is to serve as a model to show price momentum visually and as an overbought/oversold indicator. Stochastics, as well as the RSI and MACD (think of these as the 'big 3' of technical indicators of the oscillator type) are also worth their weight in gold for the occasional DIVERGENT buy or sell signal when the indicator does not 'confirm' a new high or low along with price.

I tend to use stochastics somewhat less on weekly charts. The above chart of Yahoo is an exception. I do suggest monitoring stocks or other financial items of interest such as bonds, futures and FX markets, with at least one of the 3 major oscillators on a weekly and/or monthly basis. I tend to use RSI and MACD with longer-term charts by habit and keep such a long-term chart selection 'open' in my TradeStation charting application so that I am reminded regularly of the longer-term trend and if the oscillator in question is at an extreme or possibly flashing a buy or sell signal.

Whether seen by use of Stochastics, RSI or MACD, once price action registers overbought or oversold extremes, there is simply a greater probability of a correction or trend reversal within a relatively short upcoming time frame. There being exceptions to this of course. In strong up or downtrends, the important consideration for trade entry are often trend following indicators such as moving averages.

The Slow Stochastic can be a useful indicator and quite useful in markets that are trending back and forth in a well-defined price range. That range can be a 'horizontal' one, as in the stock chart (CSCO) seen below even though its range was shifting lower over time. No doubt the sell 'signals' were the most profitable if taken as the stock kept making lower relative highs or, in the middle, a double top.

The trading range can be a back and forth trend within a wide-ranging downtrend (or uptrend) channel like this one:

That's it from me on using the Stochastics indicator. It's one that you could try out if you haven't, applying the aforementioned guidelines (and find your own!), to provide another input on shifting trends especially if used in conjunction with the chart pattern(s).


GOOD TRADING SUCCESS!