The Stochastic Oscillator The Stochastic Oscillator: Technical Tuesday with Mark Bail Mark Bail discusses the momentum gauge known as The Stochastic Oscillator. James Boric’s Note: In today’s Sleuth, Mark Bail shows you one of his favorite technical indicators of all time. It has helped him personally make and save a lot of money in his own career. And he explains how you can use it to analyze your own stock positions. Read this Sleuth very carefully. You may even want to file it away for future reference. It’s that important. Hello Again, Sleuths,In the Sept. 13 and Oct. 25 “Technical Tuesday” columns, I provided technical looks at two small-cap averages -- the Russell 2000 Growth Index (RUO) and the Russell 2000 Value Index (RUJ). In the course of those discussions, I used a number of technical indicators to interpret the state of those two averages -- to see how technically sound they were, to ascertain what type of trend they were in and to determine whether the current momentum was bullish or bearish. One of the indicators I frequently cited -- a favorite of mine -- was the Stochastic Oscillator. If you recall, in the Sept. 13 column, the Stochastic Oscillator pinpointed for us overbought condition in both averages -- alerting us to the possibility that they could be vulnerable to pullbacks. Well, that’s what happened. And recently, although I didn’t mention it in the Oct. 25 column, according to the Stochastic Oscillator, both the RUO and RUJ have moved up from oversold conditions. So as you can see, this indicator can be a valuable tool for spotting short-term market shifts -- i.e., changes in momentum. Given how valuable the Stochastic Oscillator is to many traders and investors -- including yours truly -- I thought it would be a good idea to spend some time discussing this highly useful momentum gauge. Now, over the years, a few variations of this indicator have been developed. And the Stochastic Oscillator is a very flexible analytical tool -- an indicator with a number of different trading setups. So there is a lot to cover. And we’ll get into all of it. Therefore, what I will do is devote two “Technical Tuesday” columns to this very useful indicator. Today I will discuss what a Stochastic Oscillator is, what information it imparts to you and how it’s constructed. Then, in two weeks, I’ll talk about two variations on the original version of this indicator. And I’ll also describe some of the best and most profitable ways to actually use this indicator -- to detect shifts in momentum and to uncover optimal entry points. So if you aren’t yet using the Stochastic Oscillator to analyze your positions and to support your buy and/or sell decisions, I strongly urge you read this discussion -- and the one to follow. Why am I so bullish on the Stochastic Oscillator? It’s simple. This one technical indicator has both made -- and saved -- me a ton of money. That’s why the Stochastic Oscillator is one of my favorite tools. So it’s time to delve into the world of the Stochastic Oscillator. Ready? Good -- let’s go. The Stochastic Oscillator: A Versatile Tool The Stochastic Oscillator is an extremely versatile tool -- one that can provide you with invaluable assistance in helping you decide when it’s an optimal time to buy a stock or if a market average is in the early stages of a directional move. No, it’s not the magic bullet of trading or investing. That indicator has yet to be invented. Like with many technical indicators, the Stochastic Oscillator is most effective when used in combination with either one or a group of other technical tools. And it can frequently give off false signals as well. So it’s far from perfect. But on balance, I find it to be an important part of my trading toolbox. ******************** Our Most Precious Stock Picking Secret Legendary fund manager Peter Lynch believes there is "no better tip-off to the probable success of a stock." It is one of the investment world's "crown jewels," - certainly the purest and simplest way to make money in the stock market. Win Rate = 70.15%. Gains Up To 1,386% Learn more: ******************** Well, then, what exactly is the Stochastic Oscillator? The Stochastic Oscillator is an indicator whose purpose is to compare the closing price of a stock or index to the price range of that stock or index over a specific period of time. By comparing a stock or index’s last closing price to its recent range, one can gain a sense of the current momentum of that stock or index. And that’s exactly what the Stochastic Oscillator measures -- momentum. The Stochastic Oscillator was invented by George C. Lane in the 1950s. In creating this indicator, Lane plotted the Stochastic Oscillator values in a range between 0 and 100. When you have a series of closing prices near the top of a range for a selected period of time, it is an indication that there is buying pressure in the stock or index you are measuring. This buying pressure is a clue that the stock or index is under accumulation. Conversely, a series of closing prices located toward the bottom of the range for the selected period indicates that the stock or index you are examining is experiencing selling pressure. In other words, the stock or index is undergoing distribution. Now, when the closing prices of a stock or index congregate near the upper end of its recent trading range, the value of the Stochastic Oscillator rises. Consequently, this rise in the Stochastic Oscillator offers evidence that the momentum is bullish -- and indicates that the stock or index may be about to enter an uptrend. And as the closing prices of a stock or index cluster at the lower end of its recent trading range, the value of the Stochastic Oscillator falls -- suggesting that momentum is decreasing -- and providing evidence that the stock or index may be entering a downtrend.
But the implications of the evidence offered by the Stochastic Oscillator are even more far-reaching. You see, this one indicator can also help you pinpoint shifts in momentum -- from bullish to bearish or vice versa. How? It’s simple, really. When the stock or index you are following registers a series of closing prices nearer their lows in a rising trend, the Stochastic Oscillator will start falling -- although the stock or index appears to be in the midst of a continuing uptrend. That’s an indication of an impending bearish momentum change. And when the stock or index registers a series of closing prices nearer their highs in a declining trend, the Stochastic Oscillator will begin to rise although -- from all appearances -- the stock or index appears to be headed lower. That’s an indication of an impending bullish momentum change. So the Stochastic Oscillator can help you locate these momentum shifts before the stock or index actually changes direction. We’ll come back to this point in the next column as we discuss one of the ways you can use this indicator to make -- and save -- money. ******************** Make 450% More Than Wall Street’s Best Stock Traders Over Your Morning Coffee In just 10 minutes each morning, you could earn 4.5 times as much as Wall Street's best stock wizards. Gains of 62.1% in 24 hours, 53.3% in just over two weeks and 92.5% in two days are commonplace. The secret lies in three indicators that accurately measure a stock’s Momentum, Strength and Trend. When all three indicators line up, you stand to make money up to 92% of the time. And it only takes 10 minutes a day to get in on the action. The next recommendation is coming out soon. Find out what it is… ******************** Now, think for a moment about how valuable it would be to have a signal right at your fingertips that tips you off to a potential trend change just as you are contemplating entering a position. Or imagine how useful it would be to have access to information that alerts you to a momentum shift -- say, from bullish to bearish -- in a stock you currently own. These are the some of the ways the Stochastic Oscillator can be deployed to improve your trading or investing results. Next time, I’ll describe some techniques you can employ to have this versatile technical tool assist you in making your trading or investment decisions. But before we get to that, I’d like to use the remainder of today’s column to explain just how the Stochastic Oscillator is constructed. Once you grasp the concept underlying this indicator, I think it will be easier for you to gain an intuitive understanding of some of the most common -- and profitable -- ways to use it. So let’s see how the Stochastic Oscillator is put together. The Stochastic Oscillator is plotted on two lines. One line is known as the %K. This line -- also referred to as the “fast line” -- compares the last closing price of the stock or index to its recent trading range. A second line -- dubbed the %D or “slow line” -- is a signal line that is constructed by smoothing out the %K line. These two lines -- and the ways in which they are analyzed -- are the heart of this indicator. OK, here’s how you construct the Stochastic Oscillator: First, decide on the number of periods you wish to include in your calculation. This decision is significant because --- as you will recall -- the Stochastic Oscillator evaluates the last closing price against the trading range of prices. The period you use defines the extent of the range the last closing price will be compared against -- and will have a large influence in framing the trend of the stock or index analyzed by the indicator. So if you pick a short time frame, the Stochastic Oscillator will be very responsive to each closing price. The benefit of employing a short time frame is that it will enable you to pinpoint turning points easily. However, the trade-off is that that very responsiveness could cause you to get whipsawed -- as one turning point is quickly followed by another turning point in the opposite direction. Conversely, a longer time frame will give you less frequent -- but more clearly defined -- signals. One is not necessarily superior to the other. It depends upon your personal preference and what you intend to derive from the indicator. So just make sure the time period you choose is compatible with your needs and the time frame you are analyzing. The next step is to calculate the %K line. The %K line is constructed by comparing the last closing price of the stock or index you are evaluating to the range of prior closing prices over the period you have selected. Here’s the equation: CL = Close (today) - Lowest Low (in %K Periods) HL = Highest High (in %K Periods) - Lowest Low (in %K Periods) %K = CL/HL * 100 Then, you construct the %D line. The %D line is merely a smoothing of the data that make up the %K line. This smoothing process provides you with a clearer sense of the trend of the recent closing prices of the stock or index you are putting under the microscope. By smoothing out the data, you filter out the intermittent ups and downs that frequently transpire between one closing price and the next. In the original Stochastic Oscillator formula, a three-period simple moving average of the %K line was employed to create the %D line. Five is a number often used for %K periods (the time frame) when you want to obtain short-term, highly responsive signals. However, you can experiment with different time frames so you have an indicator that suits your needs. What I have just described is the original Stochastic Oscillator developed by George Lane. However, many traders and investors have found signals generated by the %K and %D lines to be too erratic. So variants of the Stochastic Oscillator have been developed in order to reduce the volatility of the lines and to improve the accuracy of the signals. In the next “Technical Tuesday” column, I will mention two twists on the original Stochastic Oscillator. Then, we’ll get to the fun stuff -- where I will discuss a few techniques to use with the Stochastic Oscillator to catch momentum changes -- and grab profits. So stay tuned. Trade well… Mark Bail [James Boric’s Two Cents: Yesterday, Mark sent out a SELL Alert to his MST readers. He advised they take a hefty 35.4% gain on call options for shares of Internet Initiative Japan (IIJI:NASDAQ). That gain came in only four days. It marked his seventh winning play in a row -- and the 10th winner of his last 12 recommendations. Folks, Mark is one of the best analysts you will ever meet. I vouch for that with my own reputation. It’s an honor to have him run the MST Service and write for Penny Sleuth. If you aren’t a current MST reader (or even if you used to be a reader but aren’t now), you owe it to yourself to give it a try. To find out more about Mark and his MST System, click here: |
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