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Michael Bennett, Optionetics.com
August 28, 2001

Whether you’re a long-term investor, swing trader or day trader, the mantra has always been and will always be, “Buy low, sell high.”  Easy, right?  Well, if it really were that easy, I wouldn’t need to finish this article.  Since buying low indicates “cheap” and cheap is a relative term in most investments, determining what exactly is a low price for stocks isn’t always easy; particularly if stocks are on fierce uptrends or downtrends.  Fortunately there are technical indicators to help us determine how cheap a stock is relative to its trend.  Thanks to modern technology and the Internet, such indicators are not only plotted for you, but also have become (for the most part) free.  One such indicator that can help us determine a good price at which to enter a stock is the stochastic oscillator.  

First of all, any oscillator used in technical analysis is a momentum indicator that measures the rate of change of some aspect of the stock’s price relative to its past.  Stochastics compares the rate of change of the stock’s close relative to its previous closes of a given time frame.  Developed by George Lane, the theory behind stochastics is that in a defined trend, stock prices will close at the extremes in favor of the trend (highs in an uptrend and lows in a downtrend).  When prices begin to close away from such extremes, there is most likely either an imminent reversal in the trend or the stock is taking a breather before the next leg up or down.   Whether it’s the stock price or the trend that turns, the stochastic will turn as well.  Determining whether or not it’s just a shorter-term pullback or a real change in the trend can be difficult.  Stochastics can help to determine which scenario it is.

The stochastic oscillator is composed of two plotted lines %K (fast line) and %D (slow line), which range in value from 0 to 100.  The %K is the number of time periods used to measure the rate of change.  %D is simply a moving average of %K.  A third number is used in many charting programs that is a smoothing feature for %K and determines whether the stochastic reading is fast or slow.  Personally, I like to use a slow stochastic reading with a smoothing of 10.  This eliminates most of the “noise” and more easily identifies a true trend and its reversal points.  Some may like to see all of the fluctuations and may choose to use a setting of 1 or 2.

What the Numbers Mean
If the %K measures 0, then the stock is closing in the lowest percentile of its most recent range.  Likewise, if it reads 100, the stock is closing in the highest percentile of its range.   In most cases, the %K line will reverse direction prior to %D and when the lines cross over one another, be prepared for a reversal.  Should the lines come up through 80, prices are most likely closing at their highs for the time period.  Should they be coming down through the 20, they are most likely closing at their lows.  Now, should the lines come back trough the 80 or 20 in the opposite direction and simultaneously cross one another (the %K reverses and crosses over through the %D) start to look for an entry point.  If during an uptrend, the lines come down through the 20 and back up again, this is generally a good entry point for a bullish play.  And likewise, in a downtrend, should the lines come up through the 80 and reverse, you have been given a higher odds entry point for a bearish play.  To see how stochastics correlate with price, look at the following chart of Microsoft Corp. (MSFT).



Figure 1: MSFT Price Chart w/Stochastics

Another useful strategy using stochastics is looking for divergence between the stochastic chart and the price chart.  In other words, when the stock price is making higher highs and the stochastics are making lower highs (and vice versa), there’s a very good chance the trend is about to change.  Depending on whether you are in a play or not, you can use such divergence to determine a good entry or exit, particularly for longer term trades when day to day fluctuations mean less to you.  Using the same graph of MSFT as above, see Figure 2 below:

Figure 2: MSFT Price Chart w/Stochastics

As you can see, stochastics can be useful in trading the shorter-term swings for the quick 5-10 point moves, or longer-term trend reversals.  In either case, it’s never a good idea to fight the current trend. The patient trader who waits for confirmation that a trend is either still intact or has been violated will be rewarded more often than not.  If nothing else, you will save yourself from heavier losses, since you will always enter plays at better prices.  Though stochastics can be very instrumental in determining the violation of a trend, it’s not always reliable when used by itself, and can give false signals, particularly during sideways markets.  I have found this indicator most useful for me in a trending stock or index using the divergence theory.  As with most technical analysis, a trader should combine confirm direction using a combination of indicators; stochastics being just one of them.  When used in conjunction with moving averages, support/ resistance levels, MACD, you will set yourself up for a high probability trade.

Until next time, happy trading!


Michael Bennett
Staff Writer & Trading Strategist
Optionetics.com
mbennett@optionetics.com

 

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