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Stochastics
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The Stochastic Oscillator is a measure of the
relative momentum of current prices to previous closing
prices within a given interval. When it is
plotted, it is two lines that move within a range of 0
and 100. Values above 80 are considered to be in
overbought territory giving an indication that a
reversal in price is possible. Values below 20 are
considered oversold and again are an indication that a
reversal of the price trend is a higher risk. In a
strong trending environment, the Stochastic Oscillator
can stay in overbought or oversold territory for some
time while price continues in a single direction. |
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In relation to a longer term price trend
environment, the stochastic provides little interest.
In its construction it is meant to relate the current
periods momentum to the most recent previous periods of
momentum in price in an attempt to identify periods
where momentum may be easing or increasing. The
easing (at a top) or increase (at a bottom) of momentum
occurs at reversal points for the price trend being
measured. However changing momentum also occurs
during times when there is no change in the overall
trend in prices and should be understood as a period
when a reversal in price trend is possible but not
guaranteed. |
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A shorter period Stochastic
represents the trend development for a shorter period of time.
Not always is a change in the price momentum also a change in
the price trend of a stock. For any technical indications of
potential future price trend development, it is important to
build a wide body of evidence when developing an expectation for
future prices. At a reading of zero, the Stochastic Oscillator
implies that the securities close is at the lowest price that it
has traded during the preceding x periods (x being defined as
the number of periods in the calculation). At a reading of 100,
the Stochastic Oscillator implies the securities close is at the
highest price it has traded during the period of the
calculation. The basis for interpreting the stochastic is the
assumption that prices tend to close near the upper part of a
trading range during an up trend and near the lower part during
a downtrend. In addition, extreme periods are often followed by
a reversal of price trend and so are called
"over-bought" and
"over-sold" area's.
Not always will a reversal follow periods when the
Stochastic is in over-bought or over-sold area's,
however the presence in over-bought and over-sold alerts
a trader to look for further evidence that a price trend
reversal may be near. |
Other interpretive qualities of the
Stochastic Oscillator is the search for
divergences
between the oscillator and price. A divergence of peaks is
often followed by a drop in price. A divergence of troughs
often precedes a rise in price. Notice that divergences can go
against the larger price trend suggesting caution and lower
price projections as each new segment of price trend emerges.
Divergences also can continue for extended periods before any
evidence of price trend reversal occurs. A divergence that
occurs over a shorter period of time would suggest a shorter
term outlook on the reaction in prices. A divergence that
continues over a longer period of time would represent a larger
pool of activity and would be expected to result in longer and
larger period of new price trend should a reversal in price
trend result after a long period of divergence between and
indicator and price.
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The Stochastic is made up of two
lines, the dotted line is called the %D which is a moving
average of the %K which is a calculation of the securities
highest high minus the lowest low as the denominator and the
close of the current period minus the lowest low computed as a
ratio, converted to decimals and multiplied by 100.
A buy signal is given when the
oscillator falls below 20 and then rises above 20, indicating a
return of interest in the stock. This type of interpretation
requires other supporting evidence to avoid whipsaws or failed
signals. A sell signal is given when the oscillator rises above
80 and then falls below 80. The signal is the re-entry into the
mid-zone for the indicator after being in over-bought or
oversold territory. This interpretation works poorly in a
strong trending environment.
Traders also look for crossovers of
the fast stochastic (solid red) and the smoothed (dotted lines)
looking for confirming evidence of a signal to buy or sell.
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