Stochastics trace the correlation between the closing price and the recent price range. They track the power of the bulls or bears, represented by their ability to close a stock near the extreme end of the high-low range. If the bulls are strong, they will be able to close prices at or close to the highs. If the bears are strong, they will force prices lower and will be able to close them at or near the low end of the range.
If stochastics rise and then turn down, it shows that the bulls attacked but had to retreat due to a stronger force, so a sell signal lights up. When stochastics turn upward after prices were beaten down, it shows that the bears are now the ones running for cover, and produces a buy signal.
There are two types of stochastics that traders can follow: the fast stochastic, which is comprised of the %K and the %D lines; and the slow stochastic, which is a smoothed function of the fast stochastic. Stochastics are plotted between 0 and 100, with reference lines usually drawn at the 30 and 70 percent levels to mark overbought and oversold conditions.
Five days is the default in most charting packages for plotting %K. The fast line (%K) is calculated by taking today's close and subtracting it from the low price for the 5-day period. Let's say that today's close is 50, and the low price for the 5-day period was 45; the result is 5. Divide that number by the high price for the 5-day period subtracted by the low price for the 5-day period. If the high price for the 5-day period is 55 and the low price is 45, the result is 10; 5 divided by 10 is .5. Multiply the result by 100. (.5 X 100 = 50) The current day's level for the fast line (%K) is 50. The slow line (%D) is calculated by smoothing the fast (%K) line. Taking the 3-day sum of the %K equation and multiplying that number by 100 will smooth the %K.
The fast stochastic calls market turns faster than the slow stochastic, but also produces more false signals due to noise and interference. The slow stochastic eliminates the hullabaloo of the market, removing the head fakes associated with the fast stochastic. The slow stochastic is calculated by taking the slow line (%D) of the fast stochastic and making it the fast line (%K) of the slow stochastic.
The right way to use stochastics for bullish signals is:
1. If prices make a new low, but the stochastics do not confirm that low by making a higher bottom, cover shorts or go long. This indicates bullish price divergence.
2. If prices are in an uptrend and the stochastic lines move below the oversold 30 line, and then cross above the 30 line, cover shorts or go long. This indicates a pullback within the context of an uptrend and presents the opportunity to reenter the uptrend from the long side.
The right way to use stochastics for bearish signals is:
1. If prices make a new high, but the stochastics do not confirm that high by making a lower top, then sell long or go short. This indicates bearish price divergence.
2. If prices are in a downtrend and the stochastic lines move above the overbought 70 line, and then cross below the 70 line, sell longs or go short. This indicates a bounce within the context of a downtrend, and offers an opportunity to reenter the downtrend from the short side.
The chart in Figure 17-3 is a weekly picture of Adobe Systems (ADBE) with stochastic lines. In the middle of February, the fast line crossed above the slow line when the stochastics were in an oversold state, trading beneath the 30 line. After the fast line crossed above the slow line, both lines moved above the lower reference line. ADBE formed a bullish engulfing pattern and moved above the weekly 8-period moving average.
ADBE also formed weekly bullish divergence with the stochastic lines. The first bottom in the stochastic lines occurred on June 12, and the second one occurred in the beginning of August, when prices made a lower bottom but the stochastic lines made an equal bottom to the June 12th low.
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