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In technical analysis of securities trading, the stochastics oscillator is a momentum indicator that uses support and resistance levels. Dr. George Lane promoted this indicator in the 1950s. The term stochastic refers to the location of a current price in relation to its price range over a period of time.[1] This method attempts to predict price turning points by comparing the closing price of a security to its price range.

The indicator is usually calculated as:

%K = 100 \frac{\text{closing price} - \text{price low}}{\text{price high} - \text{price low}}
Stochastics can be manipulated by changing the period considered for highs and lows. In working with %D it is important to remember that there is only ONE valid signal. That signal is a divergence between %D and the security with which you are working. [2]

Contents

Definition

Stochastics Fast & Slow

The calculation above finds the range between an asset’s high and low price during a given period of time. The current securities price is then expressed as a percentage of this range with 0% indicating the bottom of the range and 100% indicating the upper limits of the range over the time period covered. The idea behind this indicator is that prices tend to close near the extremes of the recent range before turning points. The Stochastic oscillator is calculated:

Where
Price is the last closing price
LOWN( Price) is the lowest price over the last N periods
HIGHN( Price) is the highest price over the last N periods
EMA3(%D) is a 3-period exponential moving average of %K.
EMA3(%DSlow) is a 3-period exponential moving average of %D.

A 3-line Stochastics will give you an anticipatory signal in %K, a signal in the turnaround of %D at or before a bottom, and a confirmation of the turnaround in %D-Slow. [3] Typical values for N are 5, 9, or 14 periods. Smoothing the indicator over 3 periods is standard.

Dr. George Lane, a financial analyst, is one of the first to publish on the use of stochastic oscillators to forecast prices. According to Lane, the Stochastics indicator is to be used with cycles, Elliot Wave Theory and Fibonacci for timing. In low margin, calendar futures spreads, you might use Wilders parabolic as a trailing

Interpretation

When using the stochastic indicator in technical analysis, action is taken when a divergence - convergence presents in an extreme area (usually above 80 and below 20), with a crossover on the leading side. [4] As plain crossovers can occur frequently, one typically waits for crossovers occurring together with an extreme pullback, after a peak or trough in the %D line. If price volatility is high, an exponential moving average of the %D indicator may be taken, which tends to smooths out rapid fluctuations in price.

Stochastics attempts to predict turning points by comparing the closing price of a security to its price range. Prices tend to close near the extremes of the recent range just before turning points. In the case of an uptrend, prices tend to make higher highs and the settlement price usually tends to be in the upper end of that time period's trading range. When the momentum starts to slow, the settlement prices will start to retreat from the upper boundaries of the range, causing the stochastic indicator to turn down at or before the final price high.[5]

An alert or set-up is present when the %D line is in an extreme area and diverging from the price action. The actual signal takes place when the faster % K line crosses the % D line. [6]

Divergence - convergence is an indication that the momentum in the market is waning and a reversal may be in the making. The chart below illustrates an example of where a divergence in Stochastics relative to price forecasts a reversal in the price's direction.

Stochastic-divergence.jpg

Stochastics pop

This is when prices pop through and keep on going.

Rules:
Increase long position - When price crosses the upper band from below.
Increase short position - When price crosses the lower band from above.
Liquidate position - When Stochastic %D crosses %K in direction reversed to open trade. [7]

It should be noted that the existence of price oscillations is hypothetical and statistical at best--securities price movements are a consequence of the actions of human decision-makers and past behavior of market variables does not necessarily predict future behavior.

See also

References

  1. ^ Murphy, John J. (1999). "John Murphy's Ten Laws of Technical Trading".
  2. ^ Lane, George M.D. (May/June 1984) “Lane’s Stochastics,” second issue of Technical Analysis of Stocks and Commodities magazine. pp 87-90.
  3. ^ Lane, George C. & Caire (1998) "Getting Started With Stochastics" pg 3
  4. ^ Lane, George M.D. (May/June 1984) “Lane’s Stochastics,” second issue of Technical Analysis of Stocks and Commodities magazine. pp 87-90.
  5. ^ Person, John L (2004) A Complete Guide to Technical Trading Tactics: How to Profit Using Pivot Points, Candlesticks & Other Indicators pg 144-145 ISBN-10: 047158455X,
  6. ^ Murphy, John J (1999) Technical Analysis of the Financial Markets: A Comprehensive Guide to Trading Methods and Applications ISBN 0735200661 pg 247
  7. ^ Bernstein, Jake (1995) “The Complete Day Trader" ISBN 0070092516

External links

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