Stochastics is a momentum indicator popularized by George C. Lane. An overview of stochastics is presented here, enough so even a beginner can use stochastics. For more detail, a videotape instruction course is available from Windsor Books.
Stochastic theory holds that during a bull trend, closing prices will be closer to the top of the range than the bottom. Conversely, during a bear trend, closing prices will be closer to the bottom of the range. When closing prices accumulate toward either end of the price ranges, a change-in-trend usually occurs.
Stochastics use two values - %K and %D - to monitor how much "push" is in a price trend and to indicate an evolving change-in-trend. %K is the actual stochastic value, while %D is the 3-period average of %K.
The formula for stochastics is:
These values are charted on a scale from 0 to 100. The scale is divided into 3 sections - oversold, neutral and overbought.
The oversold range is from 0 to 20. When both stochastic values drop into this range, it is an indication that too much of the market has been sold and that buying could be anticipated. This will cause higher prices, with a resulting rise in the stochastic values.
The range between 20 and 80 is a neutral range. Prices and stochastics will generally react within this range, but may not result in major highs and lows, or changes-in-trend. %K will reflect minor reactions while %D will reflect the general trend. If there is doubt, my preference is to go with %D.
The overbought range is from 80 to 100. When both stochastic values enter this range, it is an indication that too much of the market has been bought, prices
may have risen too high and profit-taking is occurring. Prices and stochastic values should react to the downside.
There is only one valid signal, called divergence, for trading with stochas-tics. Divergence occurs when prices are making new highs, but the stochastic peaks are not. Even though prices are still rising, stochastics may be making lower highs. This divergence suggests a bull-to-bear price reversal might be expected.
When prices are making new lows or continue to fall, but the stochastic valleys are "bottoming out" at a higher level, divergence suggests a bear-to-bull reversal might be expected.
Stochastics are considered either "fast" or "slow," depending on the number of time periods used to calculate them. While a unique period for each market's stochastics could be determined, many chart services and software packages use a single default setting of somewhere between 9 to 21 days, with either simple or exponentially-weighted (greater values on current prices) values.
An exception to this is the G.E.T. software (listed in the Appendix), which combines 2 time periods for stochastic charting. These time periods, A & B, are weighted at 30% for A (the longer time period) and 70% for B (the shorter time period).
Chart 24 is of the September 1989 Swiss Franc. G.E.T. stochastics were set at the shorter, "faster" values of 14 periods for A, and 9 periods for B.
These shorter stochastic periods cause more up-and-down stochastic activity relative to actual price movements. More areas of divergence and changes-in-trend ("over 80" and "below 20") result. These "fast" stochastic signals, rather than being significant, might only indicate minor reactions and cause constant whipsaws, with more losses than gains in capital.
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