The Stochastic Oscillator

							              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.