Number
22
Please
note that we have used historical data. These examples
are for educational purposes only.
The fast, slow and
full stochastic
Overview
(oscillators)
Oscillators
work on the premise that markets tend to over extend
themselves on both sides of the scale. Whether these
extreme conditions are described as overbought or
oversold (momentum), strength (trend) or something
else, it is when these extremes are reached that
it is assumed the market is in a position to begin
a correction (minor or major). These extreme values
in oscillators tell us when to be watchful of the
ever dreaded and inevitable trend reversal.
Oscillators
also give us information about the general trend.
As trend analysis works with the price line, trend
analysis is also a valuable part of analyzing an
oscillator. This is where part of the "predictive"
abilities of oscillators are seen. These events
are also known as convergences and divergences.
This is when the trend of the oscillator has broken
before the price trend, and they are no longer moving
in parallel.
Here
are some general rules to use when applying your
oscillator of choice
- Signals are
stronger when they occur at the extremes
- Crossing of zero
lines and equilibrium lines should be generally
considered warning or directional signals. Strength
of these crossings should also be watched and
temporary penetrations should be ignored.
- Warnings/signals
can be generated when the oscillator is diverging/converging
with the price line.
- If the indicator
generates a signal/line cross/extreme value,
the signal/warning is stronger if combined with
a complementing convergence/divergence. (ie:
if they are still trending together (rising
bottoms/falling tops), the signal is weaker)
By using
all the information provided within an oscillator,
these types of technical indicators can be a valuable
tool in the technical analysis arsenal. In this
newsletter we will be focusing on the Stochastic
indicator.
The
stochastic, the fast, the slow and the full.
The fast
(original)
There are
three types of generally accepted stochastic formulas.
The original stochastic oscillator was developed
by Dr. George Lane and is referred to as the fast
stochastic. The stochastic's formula (%K) is based
on two observations made by Dr. Lane.
Observations
- As an uptrend reaches
it's end, closes tend to approach the daily
highs more often.
- As a downtrend
reaches it's end, closes tend to approach the
daily low more often.
(fast stochastic (9,3) on
Dow Jones Industrial Average, 1 year chart, captured
July 17, 2005)
The stochastic
has two lines, the %K and the %D. The %K is the
plotted instrument (see observations) while the
%D is the moving average of the %K. The %K is more
sensitive and it is the %D line that triggers the
trading signals.
The slow
(slow stochastic (9,3) on
Dow Jones Industrial Average, 1 year chart, captured
July 17, 2005)
Some traders
felt that the %K line was overly sensitive. To correct
this issue they smoothed the %K line. This was done
by plotting a 3 day sma of the %K line rather than
the original (fast) %K. The new %D line would be
calculated by the new (slow) %K.
What does
all that mean? Just that the new slow stochastic
is a smoothed (averaged) fast stochastic. Have a
look at the following graph,
The full
Then the
full stochastic was created. Rather than being forced
to use the 3 day SMA of the %K as in the slow stochastics,
traders felt that this should be a variable. This
created the third variable called the smoothing
variable. This changes the amount of days to be
used in the smoothing average of the %K.
You can
also recreate the fast and the slow stochastic by
the full stochastic.
To mimic
the fast stochastic, use a 1 day smoothing number.
To mimic the slow use a 3 day smoothing number.
Signals
Since the fast stochastic
%K line is quite sensitive, it generates quite
a few signal line crosses (%K crosses %D) while
the slow stochastic is a little more frugal in
it's dispensing of line cross signals. It is extremely
important with any type of stochastic to evaluate
the strength of signal generated. Here are some
good tips to help decipher what is a good signal
-
Signals
are stronger when they occur at the extremes
(crossed 80/20). Also a more conservative
addition would be to wait till it crosses
back out of the extreme value.
-
If
the indicator generates a signal/line cross/extreme
value, the signal/warning is stronger if combined
with a complementing convergence/divergence.
(ie: if they are still trending together (rising
bottoms/falling tops), the signal is weaker)
-
Crossing of zero lines and equilibrium lines
should be generally considered warning or
directional signals. Strength of these crossings
should also be watched and temporary penetrations
should be ignored.
Example of a strong
signal(s)
In this example, all
the stages are met,
- There is a divergence
between the price and the stochastics. This
should warn the analyst of an impending change
in the trend.
- This is followed
by a signal line cross and a downwards penetration
of the 80 line as well as my stochastics support
line. While this is not enough for me, some
traders might react. At this point the price
has not yet breached my trend line, however
the price has begun to fall.
-
The
%D crosses down through the 50 line. This
is a more conservative confirmation signal.
This rule also helps not reacting on false
signals.
-
Finally the %D has crossed down through the
20 line as well as the price has penetrated
it's support line. This is a considered a
very conservative signal for confirmation
that the trend has reversed. This last rule
is typically favoured by longer term traders.
TIPS
& TECHNIQUES - Using the stochastic
When using
stochastics be mindful of the effects the different
parameters make on the signals that are returned
when screening. The general rule of thumb is that
the larger the parameter, the less sensitive the
indicator becomes, the smaller the parameter the
more sensitive the indicator is.
The first
stochastic is a slow stochastic(9,3), the is a slow
stochastic (21,9). As you can see the larger the
parameter the smoother and less sensitive the stochastic
becomes.
Putting
ChartFilter into context
Here are
the following support screening signals for stochastics,
For
more information on stochastics, see our report
in the left hand column, also in the far right are
examples on how to use the WebScreener and StockTools
with stochastics.
For more
indicators click here
For screening
signals click here
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