07 Dec Technical Analysis Series: Stochastics
Like MACD, discussed in the previous Blog in the series on Technical Analysis, Stochastics is a frequently used oscillator. The formula looks complicated, but using it to trade is far simpler.
For the serious technical analyst:
The Stochastic Oscillator compares where a security’s price closed relative to its price range over a given time period. The Stochastic Oscillator is displayed as two lines. The main line is called %K. The second line, called %D, is a moving average of %K. For those interested in the formula, %K is calculated as follows: (Today’s close – Lowest low in %K periods) / (Highest high in %K periods – Lowest low in %K periods) X 100. For example, to calculate a 10 day %K, first find the share’s highest high and lowest low over the last ten days. Let us assume that during the last ten days the highest high of a share price was 100c and the lowest low was 82c. If today’s closing price was 88c, %K can be calculated as: (88 – 82) / (100 – 82) X 100 = 33.3%. This shows that today’s close was at a level of 33.3% relative to the trading range of the last ten days.
Most technical analysts, however, like to use a smoothing factor, otherwise called a slow stochastic. When using a slowing period of three days, you need to average the three highest high periods as well as the three lowest low periods before using the formula above. The moving average, %D, is displayed on top of the %K line.
The Stochastic Oscillator moves in a range between 0 and 100%. A reading of 100% indicates that the share price is trading close to the highest price in the preceding period.
Trading with the Stochastic Oscillator:
Traders normally see a buying opportunity if the oscillator falls below 20% and then rise above it. Conversely, if the %K or %D line rises above the 80% level and then falls below it, traders will sell the share.
Another way to use Stochastics is to buy when the %K line rises above the %D line and sell when it falls below the %D line. This strategy can be combined with the previous one. Buy a share only when the %K line rises above the %D line and the %K line rises above the 20% level. This is the most often used way.
The Stochastic Oscillator can also be used to detect divergence. That happens when the share price makes a series of new highs while the Stochastic Oscillator fail to surpass its previous high. That usually indicates that the bullish price movement is running out of steam.
Slow stochastics can be used effectively to determine overbought and oversold situations. Oscillators are best used in sideways moving markets and not in a strong trending bull or bear market.
Example – Bidvest:
On 18 September the Stochastic indicator gave a buy signal at about R166 when the %K line rose above the %D line and the %K line rose above the 20% level. On 11 October a sell signal was given at R180 when the %K line crossed the 80% level after crossing below the %D line a few days earlier.
Another buy signal was given on 30 October at R172 and a sell signal on 24 November at R187.
Head – Sanlam iTrade.