The stochastic oscillator and the Relative Strength Index are two of the most popular technical indicators. They are called oscillators because they move within a range, usually between 0 and 100. The stochastic oscillator is a momentum indicator that compares prices within a specific period of time. Traders can chose the amount of time intervals to be analyzed as well as the type of prices: open, high, low, or close prices. Most commonly used are the stochastic oscillators of closing prices. The stochastic oscillators
can be fast or slow. The fast and the slow stochastic oscillators have a shorter-time-period exponential moving averages %K line, and a longer-time-period exponential moving averages %D line, which is an exponential moving average of the %K The shorter-time-period exponential moving average %K is faster and reacts to price changes quicker than the longer-term exponential moving average %D. As with the MACD indicator, the fast and slow stochastics also have a signal line that is represented by the %D exponential moving average, and crosses above or below the signal line %D are used as entry or exit signals. The slow stochastic oscillator is usually preferred because it is smoother (see Figure 3.30) and shows fewer crosses of the signal line, compared to the fast stochastic oscillator, which can show erratic price moves and more frequent crosses that in some instances may produce false entry/exit signals. Both the fast and the slow stochastics oscillate in a range between 0 and 100. When there is a strong bullish trend, prices should move toward the top of the range, and within strong bearish trends, prices should move toward the bottom of the range. However, if the stochastic oscillator shows a reading above 80, this indicates overbought conditions, which is normally interpreted as an early warning sign of a bullish trend exhaustion and potential reversal. On the other hand, a reading below 20 indicates oversold conditions as a sign of potential exhaustion and reversal of a bearish trend.
There are several ways to generate entry and exit signals using the stochastic oscillator. Traders can monitor the indicator for crosses above the %D signal line, which indicate a shift in momentum to the upside and can be interpreted as buy triggers. Crosses below the %D signal line indicate a shift in momentum to the downside and can be used as sell signals. This strategy can be a bit problematic in a volatile trading environment, when crosses can develop very frequently and some of the frequent crosses may produce fake entry/exit signals followed by quick reversals that can trigger stops and cause losses. Therefore, some experienced traders tend to wait until the crosses above the %D signal line are accompanied by a cross above the 20 mark of the stochastic oscillator, which indicates oversold conditions and a potential exhaustion and reversal of a bearish trend, as well as waiting until a cross below the signal line is accompanied by a cross below the 80 mark of the stochastic oscillator, which would indicate a potential exhaustion and reversal of a bullish trend (see Figure 3.31).
A popular strategy when using the stochastic oscillator is to take advantage of divergence, or the difference between actual prices and the stochastic oscillator. Divergence can occur when prices trend in the opposite direction from that of the stochastic oscillator. Such divergences are normally considered to be early signs of extended overbought/oversold trends that may soon be followed by a trend reversal. The following
example shows divergence between actual prices and a slow stochastic oscillator. Please note in Figure 3.32 that the bullish trend in prices continues until approximately 01/01/09. However, on 12/17/09, almost two weeks earlier, the slow stochastic oscillator gives an early trend-reversal sign with a bearish cross below %D and also a cross below 80. In this example, the divergence between actual prices and the stochastic oscillator, along with the bearish cross below %D and below 80, may be considered an early sell signal based on the expectation that the bullish trend is overbought and may soon exhaust, leading to a shift in momentum to the downside and a potential reversal of the previously established bullish trend.
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