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Review (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, it 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.

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.

Parameter settings and time frames

In the following examples we will be only featuring the Full Stochastics formula.
(Review: Descriptions of the fast, slow and full stochastic) 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. For this newsletter we will be covering Full stochastics 21,9,9 -> 9,3,3. This will give us a wide enough range of options to fit most traders time frames.

! It is also important to note that this type of system is only to help timing decisions and will not help you determine the quality of the company. To determine whether a company is a good quality (undervalued/overvalued), good fundamental reasearch is necessary. Fundamentals will tell you whether a company is undervalued/overvalued and give you a better understanding of the company position within the market. Timing systems should be combined with strong fundamentals and other indicators/advisors/sources of information to be more effective.

Here are the signals generated by the full stochastic 21,9,9 using the Dow Jones Industrial Average (one year chart). In every case, when using all the information provided by the stochastic (*with trendlines), the trades were profitable.

Entry points (* study period from 10/4/05 - 9/9/05)

The above graphic shows the entry points based on a trendline and Full Stochastics %D crosses 20/80. In all three cases, we have a clear price trendline break, as well the Full stochastics %D is crossing up through 20. The objective of this timing system is to hold items for a few months or so, (preferrably larger issues), and remain in a conservative position (cash) during the wait times.

Exit points

The exits points here are more clearly defined. In each case, the Full Stochastics %D has crossed up through the 80, diverges from the price trendline, then crosses down through the 80 (sell).

In the above DJIA example, we would have only been invested for about 6 months and all trades remained profitable. While there is plenty of room to refine this timing system, it clearly shows that the stochastics indicator can be used as an effective timing system.

Different Time Frames

While using different time frames, you may also want to consider adjusting your technical indicator to suit the new chart. As seen in the lower DJIA charts, smaller parameter settings with longer term price charts generate rather volatile indicator patterns.

DJIA - 1 year daily chart

In the above 1 year daily chart of the DJIA we can see that as we decrease the values of the parameters the indicator becomes more volatile and harder to read. The longer the time frame (ie: yearly, 6 month, 3 month, etc..) you are looking at, the larger your parameters in your indicator should be.

DJIA - 3 month daily chart

If we look at the 3 month chart of the DJIA (above) we can see that the shorter parameters become more effective than the longer parameters.

Summary

Looking at the shorter term charts combined with the smaller parameters will help you zero in on the turning points while the longer term charts combined with the larger parameters help you stay with the trend.