I use a portion of the stochastic formula to exit my trades, and for the time being I thought I would introduce you to the concepts and premises of stochastic measurement. There are many variations of the stochastic model and tomorrow we will discuss the manner in which I set the parameters and setting to optimize your exit strategy.
Stochastic is an oscillator that is very popular and has been around for several decades. It is a price oscillator tracking overbought and oversold conditions. It is often used in the red light/ green light trading systems which can cause problems for traders unless they understand how stochastic works, why it was created, and what it was designed specifically to track.
Stochastic was written by George Lane and is a true oscillator which means it was primarily designed to track either overbought or oversold price conditions in a range.
In the stock market, the term “overbought” means that it can be assumed everyone who wanted to buy the stock is now fully vested and there are no more buyers or insufficient buyers to move the stock up.
Oversold is just the opposite, there are insufficient sellers to move the stock down.
The reason oversold and overbought is critical in sideways markets is that the shift from buying to selling can happen rather quickly.
George Lane wrote the indicator Stochastic formula based upon the presumption that as a run moves up (or down) a stock will close nearer to its high as buyers keep rushing in to buy the stock. But as momentum tapers off or buyers become scarce, then a stock will close lower from the high price for the day.
This is a presumptive statement that works in trading range markets. The theory fails during strong rallies and velocity markets because stochastic will move into the overbought area or oversold area signaling an exit just as the stock begins a huge run.
Therefore, Stochastic should not be used during momentum or velocity markets, platform markets, or bottoming markets as it will create a premature exit signal just as the stock is about to run up strongly. Below is a chart showing how stochastic moves to the overbought line during a strong momentum price move. This chart shows a typical platform building pattern followed by the strong velocity move up. This kind of chart pattern occurs during value-oriented markets when institutions are quietly accumulating.
During a velocity market you should use a different indicator than stochastic. Instead switch to an accumulation indicator and quality indicators as these will help you get into the stock early before the big moves up.
Below you can clearly see how stochastic is showing overbought exit signals even though the stock keeps moving up. This is why stochastic should not be used all the time but only for certain market conditions for which it was created.
Below is a chart of Stochastic showing the oscillation of the indicator suggesting overbought, or oversold conditions. This is the normal pattern that most trading systems are attempting to find. You can see that this is a very different price action than the previous chart.
The Stochastic Formula and what it is intended to reveal:
There are 2 lines for the George Lane stochastic formula: %K and %D usually represented in red and black lines on charting software. First, the K line must be calculated.
K=100((C-L)/(H-L))
Where K+ the location of price relative to the current price range
C= the last close price
L=the n-period low price
H=the n-period high price
n=any time period specified
K is smoothed twice with a 3-period SMA which creates the %K line, usually black on charts.
Then %K is smoothed again with a 3-period SMA to create %D line which is usually red on charts. Only the %K and %D lines are used in the chart analysis. So you will only see 2 lines to represent the 3 lines in the formula. Because it uses a fixed time period to period calculation, the lines can jump and move erratically if price fluctuates significantly.
Most stochastic indicators have predefined 80% overbought line and 20% oversold line on the chart. A few charting software programs allow you to move the lines to whatever percentage you wish.
If you are a beginner, simply use the settings of 80% and 20% for a trading range market.
In your article about the Stochastic indicator you mentioned using Accumulation indicators and Quality indicators for momentum and velocity markets. Can you advise on the best Accumulation and Quality indicators to use. Thanks Stan D.