The stochastic oscillator was presented by George Lane in 1950s. George Lane designed a number of indicators that withstood the test of time. These indicators rank among most popular and widely used. Lane's stochastic oscillator can warn of strength or weakness in the market ahead. As a momentum indicator stochastic helps to find turning points within the scope of the more significant trend. To achieve better result, stochastic needs to be used in conjunction with trend analysis or trend following indicators.
The best technique is to use stochastic with trend analysis to time trades in the duration of the major trend. Stochastic indicates short-term price fluctuation within the major trend support and resistance level. Using these two techniques in conjunction gives a number of excellent opportunities.
The basic assumption behind the indicator is that in an upward trend price tend to close near the highs of the day. In downward trend price tend to close near their low. The stochastic oscillator is plotted as two lines, a fast line called %K, and a slow line %D.
%K = 100 * (C LN) / (HN LN)
%K fast stochastic
C latest close price
HN highest high for N periods
LN lowest low for N periods
%D - is an 'n' periods simple moving average of %K
Usually n = 3 periods.
George Lane recommended a 14 period measurement. The number can be varied to change the sensitivity and desired time frame. Period can represent days, weeks or month.
Lane's stochastic is a percentage indicator. It always stays between 0 and 100.
Market technicians use stochastic oscillators as a timing indicator for signals of market reversal. There are three main signals the stochastic generates.
1. The level above 80% is considered as an overbought warning signal, and the level below 20% is used as oversold warning signal. This signal should be considered only in conjunction with other factors. Lane recommended waiting when stochastic rises above 80% and sell when it falls below this level. Similar for level below 20% it is recommended waiting for rise back above 20%.
The stochastic oscillator is very sensitive to the price movement and usually gives too many signals and to many whipsaws. One way to limit the sensitivity is using 5% and 95% level as more reliable. Some technicians prefer smoothing normal stochastic by 3-day simple moving average. The normal stochastic is sometimes referred as "fast" to distinguish it from smoothed "slow" stochastic. Some technicians believe that slow stochastic provides more accurate signals.
This technique is simple and elegant. Technical analysis software does all the calculations, and makes analysis easier and available not only for professional traders, but even for average investors. You can find the complete list of S&P 500 oversold and overbought stocks using the advanced technical analysis stock screener:
http://www.thegreedytrader.com/StochasticOversold.aspx
http://www.thegreedytrader.com/StochasticOverbought.aspx
2. The second important signal generated by Lane's Stochastic is the crossover between the %D and %K lines. It is considered a buy signal when the %K line rises above the %D line and a sell signal when the %K line falls below %D. To avoid whipsaws you can wait for crossover accruing within overbought/oversold area, or after a peak or bottom in the %D line.
3. The third and one of the most reliable signals is divergence between %D and the price. A bullish divergence occurs when price makes a series of lower lows while %D makes a series of higher lows. A bearish divergence occurs when price makes a series of higher highs while %D makes a series of lower highs. You can use following links to see the list of S&P 500 members that currently have bullish or bearish divergence:
http://www.thegreedytrader.com/StochasticBullishDivergence.aspx
http://www.thegreedytrader.com/LaneStochasticDivergence.aspx
Now when we know the basics, we can discuss the advanced techniques. The most important and difficult question is when to apply Lane's Stochastic. The basic assumption of stochastic is the certain market cyclicity. The simple technique will present useful signals for intermediate top and bottom in trading market, but in strong trending market stochastic is too sensitive to generate reliable signals. We would like to stress it again that stochastic oscillator is a momentum indicator. Momentum indicators help identify turning points, but it needs to be used in conjunction with trend following indicators or trend analysis.
The simplest and one of the most popular trends following indicator is the moving average. A lot of technicians use stochastic oscillator in conjunction with MACD moving average converge/divergence indicator. MACD is the trend following indicator that can help to identify the direction of the major trend. Then you can use the stochastic signals to trade in the direction of the major trend.
Use the advanced technical analysis stock screener to find a list of oversold stocks that have a substantial long-term uptrend:
http://www.thegreedytrader.com/OversoldUptrend.aspx
And the list of overbought stocks that have been in long-term downtrend:
http://www.thegreedytrader.com/OverboughtDowntrend.aspx
Using oscillators in conjunction with trend analysis and patterns recognition is probably one of the most profitable techniques devised for the experienced trader. Oversold/overbought conditions and stochastic divergence usually confirm termination patterns and give useful tips about when the current trend is about to change. The following link presents a list of oversold stocks with price near the monthly support trend line for S&P 500 members
http://www.thegreedytrader.com/OversoldSupport.aspx
And list of overbought stocks with price near the monthly resistance trend line:
http://www.thegreedytrader.com/OverboughtResistance.aspx
Trend support/resistance lines confirmed by oversold/overbought stochastic indicators and price divergence would present most reliable and accurate signals and often help to pick the bottom/top of the price trend.
