Stock traders who use technical analysis as a guideline of when to buy and sell stocks, commodities, and Forex have a number of technical indicators to chose between. Many simple indicators are available, such as moving averages, volume, and price repetition patterns (usually represented by candlestick charts). More complicated indicators, such as moving average convergence divergence (MACD) and money supply can also be used. The stochastic oscillator is one of these complicated indicators.
History of the Stochastic Oscillator for Stock Trading
Observation of stock prices by active traders showed that, just before a change in the trend of the direction of a stock price, each day the stock price would close very close to the bottom of its recent trading range. This differed from when the trend was strong, when the closing price would be near the top of its recent trading range.
To try to quantify this, George Lane, developed the stochastic oscillator, which “attempts to measure the points in a rising trend at which the closing prices tend to cluster around the lows for the period in question….” [Pring, page 231] A similar phenomenon also occurs at the reversal of a downtrend. Stock prices begin to cluster around the highs for the period in question.
Calculation and Charting of the Stochastic Oscillator
The stochastic oscillator is a calculation of a stock’s closing price relative to its price range over the time period in question. Four variables go in to the calculation.
- %K Periods – The number of periods used in the calculation.
- %K Slowing Periods – A value, typically from 1 to 3, that serves to “smooth” the stochastic calculation and avoid “whipsaws” (wild swings in the charts).
- %D Periods – The number of periods used when calculating a moving average of the %K periods.
- %D Method – the method used to calculate %D. This will be any of the normal methods for calculating moving averages.
This appears very complicated. Fortunately modern stock charting software is able to make these calculations virtually instantaneously. The results are plotted as two lines that run between 0 and 100. Values close to 100 indicate the stock is trading at the upper end of its recent range; values close to 0 indicate the stock is trading at the lower end of its range.
While the trading and charting software does the calculating, the user must establish the parameters for the calculation.
- For how many days (periods) shall the range be calculated?
- What amount of “smoothing” is desired? This will result in either “slow” stochastics or “fast” stochastics.
- What method will be used for the moving average calculation? Some charting software does not allow for change of the default method.
Most technical analysis software will include defaults for these. Values of 10 to 14 periods, and slowing factors from 1 to 3, are typical.
Stochastics in Trading Using Charting Software
Figure 1 shows a stock chart with the stochastic oscillator shown at the bottom. This particular stochastics is set for 14 days, with a smoothing factor of 3, and is considered a “slow” stochastic. Notice how the oscillator is plotted as two lines that remain fairly close together, and that they “oscillate” between 0 and 100. When the stock price is moving upward, the oscillator is closer to 100. When the stock price is moving down the oscillator is closer to 0. The two lines cross at the changes in price trend. Traders use these crossings as buy and sell triggers.
Figure 2 shows the same chart, but with lines drawn from the crossing places of the two stochastic lines to the stock price on the chart. Only the crossings near the bottom of the oscillator range are shown. Notice how, when the stochastic oscillator crossed, the stock always went into an uptrend, although the signal came a day or two after the uptrend began. The same exercise could be made for the crossovers at the upper end of the oscillator range, and use those as sell signals.
Most traders will use the stochastic oscillator in combination with other technical indicators, to help them make decisions of when to buy and sell stocks. As with all stock trading, experience with the stochastic oscillator will make its use more efficient for the stock, commodities, or Forex trader.
References:
Martin J. Pring, Technical Analysis Explained, 4th Edition; McGraw Hill, 2002
Steven B. Achelis, Technical Analysis from A to Z, 2nd Edition; McGraw Hill, 2001
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