The Stochastic Oscillator
Shared by: qxi11847
The Stochastic Oscillator Those of you who took Probability and Modeling classes may remember your professor mumbling something about 'Stochastic processes'. To refresh your memories, as stochastic process is simply a non-deterministic infinite progression of jointly distributed random variables. This means that you cannot predict the future based on past history and the present state. This is something that commodity traders have known for years --hopefully. You read the standard disclaimer on just about every trading-oriented web page (i.e. the bottom of this page) and you'll see something to the effect that 'Past results are not indicative of future results.' Just because the price went into a bearish spin after a particular head-and-shoulders pattern doesn't mean that every head- and-shoulders pattern will produce a bearish trend. However, if the price goes into a bearish spin after many head-and-shoulders patterns, you could probably say that there is a good likelihood it will do so again after a given similar pattern. In other words the probability is high for a trend reversal. The Stochastic Oscillator compares the closing price for a given period against the range of that period (high and low), and expresses it as a percentage between 0 and 100 (called the %K line). In other words, a 14 period %K would compare the closing price over 14 periods with the highest high and lowest low over that period using the formula below: Close LowestLowinN k periods HighestHighinN Periods LowestLowinN Periods 100 %K k k Where N = 14 periods. The %K line can be further influenced by a 'slowing' factor. This is just a simple moving average of the %K formula. By doing nothing further to %K, it has a slowing factor of 1, but it can be 'slowed' by as much as a three period moving average which would smooth out the appearance of the line. In addition, there is a signal line called the %D line, which is a 3 period moving average of the %K line (after the slowing factor is calculated). This is typically drawn as a dotted line that the %K line oscillates about. There are 3 different ways to use the Stochastic Oscillator: 1. Buy when the %K line rises above the 20% level and sell when it falls below the 80% level. 2. Buy when the %K line rises above the %D line and sell when it falls below the %D line. 3. Look for divergence between the price chart and the Stochastic Oscillator. This typically signals that the current trend is running out of strength. We talked about that divergence last week in our More Line Drawing session. Above is a daily chart for the March 2000 British Pound (BPH). In this case the %K line (solid pink) has a slowing factor of 1 (no slowing) and is based on 14 periods (days). It is oscillating about the smoothed %D line (dotted pink). Using the first or second method mentioned above, you would sell (short) on the third day from the beginning of the chart. Those following method 1 would get out of the trade either on the last day of the month or on the second day of the following month (November). In either case, a modest profit would be made. However, if you turned around and went long at the same time under method 1 and reversed your trade, you wouldn't have offset it until mid-December when the %K line fell back below the 80% reference line. This would have resulted in a modest loss wiping out your previous gain. Obviously, the method 2 approach wouldn't have yielded any real profits either as the %K line oscillates so much above and below the %D line that the trading losses would have eaten into your trading account. This is where the third method is most important. Notice the divergence in the two trendlines (light blue). This is a strong signal that the bearish trend is losing momentum and will soon end. It would be wise to liquidate any short positions and hold off trading until a solid indication is seen that a new trend is building. As we have mentioned several times before, it is not the best trading strategy to rely solely on a single technical indicator. This is yet another good example of that philosophy. Some traders use the MACD as a source for confirmation signals. Regardless, the Stochastic Oscillator is a widely used study that many investors have taken advantage of in the past.