Review of
the fast, slow and full stochastic
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 but 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
The full stochastic
was then 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). A more conservative addition
would be to wait until 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 generally be 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.
