Interpreting the stochastic oscillator

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Luckily, most (if not all) charting software calculates the stochastic oscillator for you, so you don't need to memorize or even fully understand the formulas behind it (whew!). You really just need to know how to interpret the lines on a chart. For a depiction of how the stochastic oscillator shows up on a chart, refer to Figure 11-10. This is a chart of the same INTC data in Figure 11-9, but the RSI has been removed, and a stochastic indicator has been inserted.

When interpreting the stochastic oscillator, you use methods similar to those used in interpreting the RSI and moving averages (see respective sections earlier in this chapter).

Using stochastic oscillators as you would two moving averages

Knowing how to use two moving averages is helpful when interpreting stochastic oscillators. For defining a trend, if both the fast (%K) and slow (%D) stochastics are trending higher, and the fast line is higher than the slow line, you're looking at an uptrend. It's like when you're using two moving averages, and the moving average with the shorter look-back period is up above the moving average with the longer look-back period: The trend is considered up.

Another parallel to using two moving averages is that a change in trend may be signaled when the fast stochastic changes from being over or under the slower stochastic. Keep an eye out for those important changes.

The rule on this is if the fast stochastic is above the slow one, an uptrend is in place; if the fast one is under the slow one, a downtrend is in place. When they cross, there's a trend change! When they are in overbought territory and the fast one crosses under the slow one, that may be considered a good selling opportunity. Conversely, when they are in oversold territory and the fast one crosses over the slow one, it's a good buying opportunity.

Using stochastic oscillators as you would the RSI

You can use the stochastic oscillator as an overbought or oversold indicator, just as you use the RSI (covered in the section, "Examining the Relative Strength Index"). Like the RSI, both the fast and slow stochastic levels oscillate between 0 and 100 percent. Below 30 is considered oversold (a buying level), and above 70 is considered overbought (sell level).

The benefit of having a slow and fast stochastic is that when the overbought or oversold levels are reached and a corresponding crossover of the fast and slow stochastic occurs, you can enjoy a much more reliable signal. For example, if both of the stochastics are in overbought territory, and you see the slow stochastic move from over to under the fast one, that's considered a sell signal. The reverse is also true: If both stochastics are oversold, and the slow one moves from under to over the fast one, that makes for a nice buy signal.

Stochastic Slow (High, Low, Close, 14, 3, 3, 1,20, 80) 95.13 90.66 80.00 20.00

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Figure 11-10:

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A chart of INTC with

70.0

50.0

stochastic oscillator.

10.0

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