Stochastic Oscillator

Stocks & Commodities V. 2:3 (94-97): STOCHASTIC OSCILLATOR by Harry Schirding

STOCHASTIC OSCILLATOR by Harry Schirding

S

tochastic is an oscillator, that like the Relative Strength Indicator (RSI) or Contary Opinion, can be

used to indicate an overbought or oversold condition. The process has at its root an observation that in rising markets, prices tend to accumulate near the upper end of the day's trading range. The observation also follows for falling markets that the close will tend to accumulate near the lower end of the day's trading range. The result of computations described below will net two indicators, the "%D" and "K", which are plotted together to give a visual picture of the overbought or oversold of the data base used. The following paragraphs describe two separate methods that can be used in the computation of the stochastic. The first method uses two formulas that will compute the values for "K" and "%D" respectively. The second method will make use of a table (figure 1) to arrive at the same values for "K" and "%D". Both of these methods will compute the regular stochastic and a smoothed stochastic referred to as the slow stochastic. TABULAR METHOD 1) The first step in this second method makes use of a sheet of paper that has been divided into sixteen columns and has each column titled as shown in figure 1. Fill in columns 1, 2, 3 and 6 with the date, high, low, and close respectively. (2) Now check back over column 2 for the highest high during the last five day period including today and write the value in column 4. Do the same for the lowest low during the last five days including today and put the figure in column 5. As you write these values in the appropriate column convert the fractional parts into eighths. Eg. 327 1/2 would be 327 4/8. The use of five day high and low is the one suggested by one the authors, George Lane, and could be optimized for each commodity after the process is better understood. 3) The difference between the columns 4 and 5 should be written in column 7 and the difference between

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Stocks & Commodities V. 2:3 (94-97): STOCHASTIC OSCILLATOR by Harry Schirding

column 4 and 6 should be written in column 8. The numbers in columns 7 and 8 should be expressed in eighths as the following example illustrates: If the difference were 4 6/8 then the value of the column would be 4×8=32 32+6=38, so the column value for one of these two columns would be 40. 4) The difference between column 7 and 8 is written in eighths in column 9. (To check your math each day add column 8 to column 9 which should equal the value of column 7.) 5) Total the values for the last three days is column 7, including today, and write the result in column 11. 6) Total the values for the last three days in column 8, including today, and write the result in column 12. 7) Total the values for the last three days in column 9, including today, and write the result in column 13. To check the math each day add column 13 to 12. The result should equal the value of column 11. 8) Divide column 7 into column 9 and place the answer in column 10. Note that the answer should be in the format of XX.X%. 9) Divide column 11 into column 13 and place the answer in column 14. To check for math errors add column 8 to column 9. The result should equal column 7. Likewise adding column 12 and 13 should equal column 11. 10) A smoothed value for the stochastic can be obtained by using the last two columns. A total of the last three days from column 14 is placed in column 15. Divide column 15 by three and place the value in column 16. For the slow stochastic that we have just computed column 14 is changed and now represents the value associated with "K" while the new smoothed value for "%D" is now found in column 16. INTERPRETATION Now that we have done the calculations and arrived at the values necessary to plot the stochastic, we should spend some time trying to see what this study can tell us about the character of the market. If we look at figure 2 we see the plot of the stochastic on the lower half of the chart and price represented on the upper half. Notice that as the "%D slow" (solid line) and "K slow" (dash line) rise from their origin that the "K" line will cross the "%D" line, on the right, then the two usually change direction until the next cross of the "K" and "%D". The crossover forms the basis for interpretation of the stochastic. Divergence of the "%D" line and the stock or commodity's price is a signal of prime importance. Divergence can be defined with an example: when the price of a commodity or stock make a high, react, then make a higher high while the line representing the "%D" makes a high then makes a lower high, this is called a bearish divergence. The same holds true for lower price movement after a reaction high, while the "%D" fails to make a lower low, thus we have a bullish divergence. The crossover is then the signal to act based on a divergence signal. Divergence is then one of the tipoffs that there could be a change in the trend of that market. Other indications that we can use are the warning and failure. A warning occurs when the direction of the "K" line changes sharply but does not cross "%D" line that day. This would indicate that a crossover of the "K" and "%D" is probably within two days. A failure occurs when the "K" line after crossing through the "%D" pulls back a few percent but does not cross back thru the "%D" before moving higher. This signal indicates strength and will usually be followed by higher highs for both price and "%D".

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Stocks & Commodities V. 2:3 (94-97): STOCHASTIC OSCILLATOR by Harry Schirding

I feel that the place to start this analysis is with either a weekly or monthly chart. In this case we will use the weekly chart in figure 2. The bar chart says that we are definitely in a down trend and will remain that way until the price manages to penetrate the trend line A. The stochastic chart seems to confirm the analysis since the trend line "C" shows no divergence to the bar chart. There is an example of divergence on this chart when we examine the lows. As the bar chart makes lower lows the stochastic is making higher lows. This signals that we could be near the price low for this move down. The confirming stochastic signal would be divergence with the bar chart highs and a move above the trend line "C". The weekly or monthly chart should be used as an indicator of which signals to accept and which to ignore on the daily chart. In this case to follow the rules one should ignore the daily sell signals since the weekly has turned long. A good technician would probably also check the monthly stochastic to see which side of the market it indicated. In this case the monthly confirms that we are still in a down trend so the weekly chart is alerting us to the possibility of a market turn around in the near future. Notice also that before the "K" line crosses the "%D" the slope of the line changes and may turn down a period of time before the actual cross over. This is a warning that a crossover may be within one or two days and you should take the necessary precautions. I use almost exclusively the slow or smoothed values for "%D" and "K" because they tend to be more confirmed signals, although they usually appear several days after a signal is generated using the regular method. Let us now turn our attention to the daily price chart in figure 3. We see the bar chart confirming that the markets indeed are in a down trend, having not closed above the trend line since before the first of November. There is no divergence between the price and the "%D" plotted on the lower portion of the chart. It is important to note that trend lines can suggest points that may offer resistance or support to the "'%D". During the month of January, only once were the trend lines on the stochastic chart penetrated and then within two days the indicator had again closed within the lines. It seems the signals that have the most validity tend to occur above 85% and below 15%. Generally if the "K"-line declines to a value of zero then a small rally of from two to five days will precede the attempt of the "K" to reach zero again. After this occurs there is a good chance that there could be at least a minor rally. The opposite is true when "K" approaches one hundred. It will usually fall back, then retest the one hundred mark again, only to fall into a minor sell-off. Notice that after a signal below the 20% line the indicator rallied but failed below the 80% line. All was not lost because the next signal was higher than the previous low while prices were making a new low. This would indicate that prices should go higher at least until a signal is given above the 80% line. As with any indicator, the system is by no means fool proof, so the process should be used along with and confirmed by other indicators that draw on a different type of signal. The stochastic seems to be a good coincidental indicator at best, so there must be some other method used that will give the entry and exit signals. Many times the move can be half over before a confirmed signal is given. This is not too hard to understand since in the computation of the indices great weight is given to the values of the five day high and low. With study of the computations comes a better understanding of not only how each number is arrived at but also insight intra-day what price action may be doing to the "%D" and "K" values. How much homework you do will have a great deal to do with your success in trading with the stochastic.

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Stocks & Commodities V. 2:3 (94-97): STOCHASTIC OSCILLATOR by Harry Schirding

Figure 1

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Stocks & Commodities V. 2:3 (94-97): STOCHASTIC OSCILLATOR by Harry Schirding

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