Using the stochastic indicator can increase the probability of buying at the right moment. Stochastic is one of the most useful tools for stock market technical analysis available for investing and trading. The discussion in this chapter will assume familiarity with the concepts of overbought/ oversold divergence that were introduced in Chapter 1: Introduction to Indicators and the general discussion on momentum indicators at the beginning of chapter six.
The stochastic is a popular momentum oscillator developed by George Lane. While it does the same job as the relative strength index (RSI) discussed in chapter six, it does it somewhat differently. RSI measures momentum by comparing the closing price with the previous closing price. The stochastic takes a quite different approach.
We saw that, in an uptrend, the closer the closing price is to the high, the more committed the buyers were at the end of the period. Likewise, in a downtrend, the closer the closing price is to the low, the more committed the sellers were at the end of the period.
The stochastic uses this idea. It takes a number of trading periods (days, weeks or months) and calculates, as a percentage, how far the last closing price is from the lowest low for the number of trading days chosen.
So, if we are calculating a five-day stochastic, and the range for the last five days was from $1.25 to $1.35, if the closing price on the fifth day was $1.25, then the stochastic would be zero. If the closing price on the fifth day was $1.35, then the stochastic would be 100.
These are the two extremes, because, as a percentage, the stochastic fluctuates between zero and 100. Any other closing price between $1.25 and $1.35 will give a value for the stochastic between zero and 100.
Like the RSI, the stochastic will tend to swing upward when prices are rising and downward when the prices are falling, mimicking the price movements. Unlike the RSI, which is a single line, the stochastic has two indicator lines.
The line that has just be described is called %K. The other line, known as %D, is the %K that has been smoothed mathematically. The names of the two lines seem to refer to the two of many alternatives that Lane selected as the most useful from all the options he tested. The standard parameters are five days/ weeks for %K and three days/ weeks for %D.
Chart 7-1, shows a daily bar chart of St George Bank with standard (STO) and slow (SSTO) stochastic. In practice, the standard stochastic described above jumps about far too much, except for very short-term trading. To make it more useful, longer-term traders and investors use a variation called the slow stochastic. The %D of a standard stochastic becomes the %K of the slow stochastic and a new %D is c calculated, smoothing the new %K as was done previously in the standard version.
The stochastic has a different scaling to the price, so it is usually charted in a sub-chart below the price chart. Chart 7-1 demonstrates how this is done, with the lines labeled (%K is always the one that is more volatile). In chart 7-1, there are two sub-charts, the top one showing a five-day standard stochastic (STO) and the lower one showing a five-day slow stochastic (SSTO). Overbought and oversold lines are shown on the charts in this chapter, at the standard settings of 70 and 30 respectively. However, many analysts find that the best signals are given using 80 and 20 respectively.
Divergences are assessed using the less volatile of the two lines, %D. As well as the standard divergences described in chapter one, Lane identified what he called a classic divergence signal, which is a variation on the triple divergence mentioned in chapter six. In Lane’s classic divergence, there are three peaks and three troughs:
- In an upward movement, there is a standard divergence, followed by a third peak, which is higher than the second peak, but lower than the first peak, as shown diagrammatically on the left side if Diagram 7-1. There is an example at C on Chart 7-2. It is perfect on both standard stochastic %D and slow stochastic %D; however, the third peak of the price is only equal to the second peak, not higher. Many analysts regard this as a valid signal.
- In a downward movement, there is a standard divergence, followed by a third trough, which is lower than the second trough but higher than the first trough, as shown diagrammatically on the right side of Diagram 7-1.
Lane’s classic divergence is regarded as a stronger signal than the standard divergence, which only has two peaks or troughs.
Rules for the Stochastic in a Sideways Market
- Rule 1: Buy on a %D divergence, particularly when the first trough is below 30. Chart 7-2 shows a good example at A on both the standard stochastic and the slow stochastic.
- Rule 2: Sell on a %D divergence, particularly when the first peak is above 70. There is an example at B on Chart 7-2, followed by a Lane’s classic divergence on a larger scale.
One reason for showing both the standard and the slow stochastic on Chart 7-2, is to demonstrate that the signals are earlier on a standard stochastic. The days of the signals, are marked with solid vertical red lines. Action would be taken the following day, because the stochastic is calculated on the closing price. This underlines that a standard stochastic is better for trading sideways markets, where quick action can be required.
Rules for the Stochastic in a Trending Market
These rules are based on the idea that we only take signals from a momentum oscillator to buy into uptrends. Where we are looking to sell out of a trend, only short-term traders should act on the stochastic by itself. When a long-term trader or investor is looking to capture a large park of the trend, they would sell based on a trend-following indicator and use the stochastic only for additional confirmation.
- Rule 1: When either %K or %D crosses below 30, buy if the price rises above the high of the signal day. The Stop-Loss level is any sale below the low of the signal day. If the high of the signal day does not generate a buy, any subsequent day that makes a lower low becomes a new signal day.
This rule sounds quite complicated, but it is simply a way to try to buy the first uptrending bar after a decline .Diagram 7-2 shows the simple possibilities. But there are some other possibilities in addition to these. The day after a signal day may be an inside day, which has a lower high and a higher low. Ignore it and continue with the existing signal day.
But let’s assume the day after the signal day is an outside day, with a higher high and lower low:
- If the high is made first, we will buy and then our stop-loss level would later be triggered, making a loss. However, the outside day becomes a new signal day.
- If the low is made first, we will buy as usual, but the day’s low becomes the reference point for the stop-loss level, instead of the low of the signal day.
Chart 7-3 shows a daily bar chart of Woodside Petroleum with a 14-day slow stochastic. This chart is a small part of a well-established uptrend we might have been trying to enter. As you can see on the chart, the rule one signal for using the stochastic in a trending market came towards the end of March and resulted in a buy the following day, as can be seen on the chart.
This positioned us just after the low of a trough in the trend. This is a perfect example of rule one in action.
However, later in Chart 7-3, things do not go so well. If we had been trying to buy when the first signal came in May, we had to sit out for two days, during which the price did not make a new low or exceed the high of the signal day.
Three days after the signal day, we would have bought, as marked on the chart. However, compared to March, this was not as good a place to enter the trend.
Things can go really pear-shaped even with a rule that often works quite well. The second signal in May on Chart 7-3 would have caused us to buy on the following day.
However, the price fell through our stop-loss the very next day, taking us out at a loss. This has happened because rule one is trying o get us in near a trough in the trend. We need the stop-loss because, if it is not a trough, it could be that we are in a downtrend.
What is really galling about this is that if the signal day has been one day later, the final signal day would have been the bar that made the low of the trough and we would have bought on the following day.
This is tough, but it happens in real life. It remained to be seen if that turned out to be a trough in the uptrend or the beginning of a new downtrend.
- Rule 2: Use trend-following indicators to sell out of an uptrend. Divergence on the stochastic %D may be used to take profits in an uptrend, but unless confirmed by a trend-following indicator, these are not likely to be the final peaks in the trend.
In late 2000, there are two divergences on the slow stochastic. However, there was no subsequent confirming sell signal from the moving average.
Then, as the second half of 2001 unfolded, there was first a simple divergence and then a Lane’s classic divergence on a larger scale. The next dip in the Woolworths trend brought confirming sell signals on the moving average.
However, the uptrend was not over. An intrepid investor may have bought back into it. Then as mid-2002 was approaching, another lane’s classic divergence unfolded. Its last peak was the high peak of the trend. This divergence was confirmed by a sell signal on the moving average about eight to 10 weeks later.
This example shows how rule two can give confidence to ignore premature divergences on the one hand and then be alert for important turning points on the other.