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Stochastic

The stochastic oscillator compares a stock’s closing price to its high and low prices for a particular period. The assumption is that as stocks trend upward, the closing prices end on the high side for the specified period. Conversely, as stocks trade downward, they tend to close towards their low price for that specified period.

The stochastic indicator is charted on a regular vertical/horizontal chart. The scale of the vertical axis is measured from 0 to 100, while the horizontal axis reflects the time periods.

The stochastic indicator has two trendlines, as follows:

  • %K – is a comparison, expressed as a percent, of the stock’s closing price to its high and low for a specified time period. % K is considered the fast line.
  • %D – is a 3 period (usually days) moving average of the % K trendline. %D is considered the slow line.

It is extremely important to understand the calculation of the %K trendline. The formula is below:

%K = [(C-LP) / (HP – LP)] * 100

or

%K = [(Closing Price – Low Price (N)) / (High Price (N) – Low Price (N))] * 100

Where:

N = Number of periods

For example, if a stock closed at $10 and had a high of $11 and a low of $8 for a day, its % K chart point would be calculated as follows:

%K = [($10 - $8) / ($11 - $8)] * 100

%K = 66.67

Fast vs. slow stochastic: when plotting the %K and %D lines, %K often crossed over %D, causing analysts to misread the ultimate direction of the fast trendline. This resulted in a newer slow calculation of the %K that smoothed the results, making them easier to interpret. Instead of using the raw values of %K, the slow stochastic uses the 3-day moving average of the raw data. Then, %D is re-calculated based on the new % K values. The fast stochastic uses the raw data to produce the %K trendline, while the slow stochastic uses a 3-day moving average of the raw data. %D is always the 3-day moving average of %K.

Below is a diagram of the fast and slow stochastic indicators, using Verizon as the subject. Verizon is an interesting stock play; you have to wonder if the growth in its wireless division can offset the decline in landlines and the inroads of the cable companies. The risk seems to be already factored into the stock; its current shareholders should do well.

Reproduced with permission of Yahoo! Inc. ă 2004 by Yahoo! Inc.
YAHOO! and the YAHOO! logo are trademarks of Yahoo! Inc.

The main objectives in using the stochastic oscillators are listed below:

  • To identify overbought and oversold securities. It is believed that when the indicators rise above 80 a stock is probably overbought, while if the indicators are below 20 the stock may be oversold.
  • To identify trend reversals and buy and sell signals. When the %K line crosses over and raises above the %D line, a buy signal is generated. Conversely, a sell signal is generated when the %K trendline crosses over and falls below the %D line.
  • To identify divergences between the actual stock prices and the oscillators. This often indicates that a reversal back to the normal trendline is in order.

A buy signal is generated when the stochastic indicators fall below the 20 level, then reverse and rise above it. Conversely, a sell signal is generated as the stochastic indicators rise above 80 then fall below that level.

It is also important to understand the signal that the trend is generating. One should be very cautious if you have a security in an overbought reading, or shorting a security in an oversold market. Momentum investors, however, specialize in buying with the trend.

Don’t necessarily sell a security in an overbought range. This is where profits are made. A stock can stay in an overbought range for a long time. Stay with the trend until a reversal signal is determined.

There is also a third version of the stochastic indicator called the full stochastic. The full stochastic is a more advanced version of the fast and slow stochastic, using different time frame scenarios.

The stochastic approach of using two trendlines to predict future price movements based on a stock’s historical high, low, and closing prices was innovative, and is now a proven stock timing technique that can be of value to investors.

Click below for information on specific oscillators:
Rate of Change
Relative Strength Index
MACD
Price Oscillator
Money Flow Index
Williams %R
Volume + Moving Average

 

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